S&P 5905 Target up 88% and the Fed Model’s Flaw

We revised our S&P 500 2020 Fed Model price target up to 5905 (up 88%). This letter reviews how recent decades of extreme Central Bank accommodation has distorted the Fed Risk Premium Model’s credibility when compared to other valuation models which are more cautious.

The 2020 Rally:

The Federal Reserve is lowering short term rates and adding liquidity through Repos and Treasury Bill purchases. Recent months’ potential black swans like the Hong Kong Riots, Brexit, the US-China trade negotiations, the Presidential impeachment inquiry and the global industrial slowdown have all de-escalated. If trade frictions, which have reduced corporate capital spending, are reduced through credible trade agreements with China, the EU and through the USMCA, a recovery in earnings and the industrial economy should ensue. Further, if centrist Democratic candidates like Michael Bloomberg gain traction with voters, presidential elections risks will decline. If these improving monetary, economic, international and political factors, combine with improving market technical and momentum factors, a 2020 US equity market rally could make S&P 5905 seem more plausible.

The Fed Risk Premium chart combination below shows the red earnings line in the second panel turning up. With S&P 500 earnings turning up, the earnings downturn risk that triggered the major market peaks of 2000 and 2007-9 is removed and a more material equity market advance could develop.

The Fed Risk Premium Model above shows the Risk Premium is currently an attractive 3.77%. This reflects the S&P 500’s earnings yield of 5.55% is 3.77% higher than the 10-Year US Treasury note yield of 1.78%. The S&P is undervalued by this measure.

In the Fed Model Databox below we estimate that, with a global economic recovery, S&P 500 earnings will grow 10% to $179.70 for the S&P 500. Further, we assume a normalization of US Treasury yields to 3.0% on the 10-Year US Treasury note. Using the exuberant risk premium of 1.2 registered in the 2007 peak of 1.2%, our Fed Model S&P price target is now 5905 up 88%.

This optimistic Fed Model Risk Premium forecast is contrasted with the valuation methodology of Robert Shiller’s Cyclically Adjusted Price Earnings Ratio or CAPE and Warren Buffett’s “favorite indicator” of Equity Market Capitalization divided by US Gross Domestic Product. These are shown below:

The CAPE chart shows the Cyclically Adjusted PE Ratio is 30.

Shiller’s CAPE Model shows the market to be at valuation levels only exceeded during the 1929 and 2000 market bubbles. Current high CAPE valuations should be noted for occurring during a period of abnormally low interest rates.

The Buffett valuation below shows prices near historic highs and this measure is corroborated by Buffett’s very large cash holdings in Berkshire Hathaway.

Why the Large Valuation Disparity?

The artificially engineered low interest rates of the last few decades have contributed to these two ominous overvalued readings by Shiller and Buffett. The weakness in the Fed Model’s bullish forecast is due the low quality of its earnings. Austin Rogers aka Cashflow Capitalist details his thoughts on Seeking Alpha.

In short, the financial accommodation of Central Banks has allowed earnings to grow through to cost cutting and stock buy backs. These corporate actions allow for earnings growth without normal revenue growth. The financially engineered consequences of cost cutting and share buybacks have also led to lower quality earnings. Today, both price to book and price to revenue are at extremes. The S&P 500 is trading at a price-to-sales of 2.2x, well above the 1.7x reached in late 2000. Further the S&P 500 current price-to-book value of 3.3x is well above the 2.9x reached prior to the 2008-9 Financial Crisis. This Central Bank induced process enriches corporate managements while leaving middle and lower classes, labor and retirees with disproportionately smaller shares of the economic pie.

In our bullish forecast, we anticipate significantly reduced trade tensions and a global economic recover. This will lead to higher interest rates, greater capital expenditures and tighter labor markets. The stock market leadership will shift from past winners to lagging sectors including energy, industrials, financials, small caps and precious metals.

Market Momentum Increasing:

The Charts below by Ari Wald, CFA, CMT of Oppenhiemer show broadening stock market breadth and a historical precedent for continuing bullish momentum.

The chart below shows small caps turning higher, telegraphing a stronger market.

The Case for Energy Investments:

The weakness in energy has approached extremes. This December will be an exceptional trading and investment opportunity in oil and gas. Fossil fuels and ESG divestitures are driving “ethical” sales and creating extreme bargains in the energy space. The S&P Energy sector’s market capitalization is now less than Apple’s $1.2 trillion. Additionally, the world’s largest company, Saudi Aramco is expected to sell 1.5% of its shares at a valuation of $1.7 trillion dollars. This impending $27 billion dollar stock sale combined with year-end tax loss selling creates a rare supply demand imbalance for opportunistic energy traders and investors.

Last year, at this time we recommended KYN Kayne Anderson MLP closed end fund and enjoyed a significant tax loss bounce that we believe will be repeated. KYN is a high-quality high yielding closed end fund trading with a 11.45% yield and a discount to Net Asset Value of 9.5%. MLPs provide pipeline and fee-based services, which are less cyclical than other businesses within the oil and gas industry. Consequently, KYN’s combination of a high yield, stable earnings, discount to NAV, tax bounce prospects and technical factors make this diversified energy fund an exceptionally attractive opportunity. Last year, a similar scenario occurred, and we bought KYN for our clients; we will do so again this December. The Chart below shows last year’s December KYN purchases led to a bounce on the order of 25% of a high-quality income producing asset.

Precious Metals and Gold:

Gold is a traditional safe haven asset which we have been adding to our client portfolios. Gold has performed particularly well this spring as the Chinese US trade war became increasingly confrontational. We continue to see gold performing positively as a safe haven to international risks and as a hedge to the S&P 500 when this bull market ends.

The long-term chart of the gold ETF (GLD) below, shows a long base after peaking in 2011 and a resurgence in strength in the last two years.

The one-year chart below of GLD shows gold pulling back during the recent market rally but now reversing.

Conclusion:

We are optimistic on the market and the economy and are cautiously investing capital in select out-of-favor investments over recent year’s stock market leaders. After four decades of declining interest rates, declining interest rates will no longer be an important support to the stock market. Consequently, new leadership will emerge as the economy strengthens and equity markets broaden.

We wish you a Joyous Holiday Season and a Happy New Year.