Vol. 2, No. 13
Vol. 2, No. 13
Stocks are modestly undervalued; The plug has been pulled from the monetary bathtub; We're adrift in a sea of private debt; Finding value in vending machines.
Valuabl is an independent, value-oriented journal of financial markets. Delivered fortnightly, Valuabl helps investors pop bubbles, buy low, and sell high.
HOUSEKEEPING
In past issues, it was unclear whether earnings forecasts for the S&P500 valuation were mine or analysts’ consensus. The timing of those forecasts was also unclear. Sorry. I’ve tried to make it more explicit.
In today’s issue
Cartoon: Tech bosses be like…
Cost of capital (4 minutes)
Global stocktake (3 minutes)
Corporate shuffleboard (3 minutes)
Credit creation, cause & effects (9 minutes)
Debt cycle monitor (2 minutes)
Investment ideas (10 minutes)
“The less money lying idle the greater is the dividend.”
—Walter Bagehot
Cartoon: Tech bosses be like…
Cost of capital
Interest rates and capital costs are the most consequential yet misunderstood prices in capitalism, connecting the future to the present.
•••
Stock markets fell over the past fortnight. The S&P 500, an index of big American companies, dropped 9%. The index has fallen 21% since January, its peak, and 11% over the past year. Investors wiped $9trn off global equity markets (see: Global stocktake) and marked up the price of risk for both equity and credit.
Investors are grappling with the spectre of inflation. Central banks are raising rates, hoping to reduce job vacancies without job losses. Punters reckon this will lead to a recession. This prospect looks increasingly likely, and a soft landing, slowing economic growth with acceptable collateral damage, is increasingly unlikely. What do you think?
Government bonds fell alongside stocks—a marker of monetary tightening. Yields, which move inversely to prices, rose despite falling inflation expectations. Yields on ten-year Treasury bonds, a key variable for valuing financial assets, increased by 28bp to 3.3%. Bond investors’ forecasts for inflation over the next ten years fell by 14bp to 2.6% per year.
Consequently, the real interest rate, the difference between yields and expected inflation, rose by 42bp. Fixed-income investors expect to increase their purchasing power by 0.7% per year. This return, albeit tepid, is 174bp better than it was at the start of the year. In last fortnight’s issue, I noted that at the prevailing interest rate it would take 347 years to double your purchasing power. Now it will only take a century. One hamburger now, or two for your grand children?
The equity risk premium (ERP), the extra return investors want for buying stocks instead of bonds, erupted. It rose 50bp in the past fortnight as recessionary fears mounted. The current 5.7% premium is higher than the average over the past five years of 5.1%. The premium has risen 93bp since January and 174bp in the past year.
The cost of equity, the return stock-investors demand to part with their money, is 9%, up 78bp from last fortnight when Valuabl last went to press. Equity costs—which we can think of as expected returns—have risen 272bp since January and 355bp in the past year.
Creditors marked up risk last fortnight. Corporate bond prices fell more than government ones. Credit spreads, the difference between corporate bond yields and Treasury yields on BBB-rated bonds, rose 16bp. These spreads are up 64bp since the start of the year and 77bp over the last 12 months. Risk is becoming more expensive, particularly at the speculative end.
Using the average ERP of the past five years, the current ten-year Treasury bond yield, analysts’ consensus earnings estimates, and a stable payout ratio based on the S&P 500's average return on equity over the last decade, I value the index at 4,205 compared to its level of 3,760.
This valuation suggests the S&P 500 index is 11% undervalued compared to 9% overvalued at the start of the year and 20% overvalued last year. Although the prospective stock purchaser can expect a 9% per year return at these prices—decent but nothing to write home about—the index isn’t especially good value yet. Hold your horses. Don’t go all-in.
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