U.S. stocks, why is not yet plummeting?

I’ve said before, whether it’s the stock market or other markets, every stage will trade a certain theme.

In the case of U.S. stocks, for example, before the 2020 epidemic, the trade was “recession”, and when the epidemic really broke out, it was trading “epidemic spread”, and when the epidemic spread became clear, it started trading “vaccine R&D” and “monetary policy stays loose”, then, start trading “rapid economic recovery” until the end of 2021, when the market starts trading “interest rate hikes “……

Since 2022, when rate hikes became explicit and stronger, the market began trading “Fed rate hike slowdown”, and just recently, the theme seems to be moving from “rate hike slowdown” to “recession “transition.

Someone said, since the U.S. stocks have turned to trading “recession”, and according to the judgment of many economists, the U.S. economy in 2023 is almost certain to fall into recession, that –

Why are U.S. stocks not plummeting?

When it comes to this issue, I can’t help but sigh at the magic of U.S. stocks, as one of the world’s largest risk markets.

What is the magic?

The magic is that it is really a “too standard” market.

Why do you say that U.S. stocks are too standard?

Because most of the models you use to estimate the point of U.S. stocks at a given moment seem to be “at normal levels”.

Here, we might as well use a few historically tested models to assess the current U.S. stocks, whether or not they are located in a “reasonable range.

The first model we use is the Federal Reserve valuation model (Fed Model).

This model, which was popularized by Ed Yardmen when he was an economist at Paulson Securities, mainly compares the expected return of stocks (Forward EPS) with the current U.S. 10-year Treasury yield, and when the expected return of the stock index is less than the 10-year bond yield, it indicates that stocks are overvalued, and vice versa.

In the case of the S&P 500, the model means that

Stock Index ≈ Expected Earnings Per Share (Forward EPS) / 10-Year Treasury Yield.

Why does this model exist? It is because analysts have found that when investors are optimistic about stock expectations, the stock market is bound to rise sharply, which brings about a significant decline in stock market yields as an indicator of sentiment, and smart people will consider choosing bonds; if people are more pessimistic about stock expectations, then the market will fall significantly, which brings about a significant rise in stock market yields, and smart people will sell bonds and choose stocks.

Essentially, the Fed valuation model is a binary model in asset allocation – holding both bonds and U.S. stocks, using the 10-year Treasury yield as a yardstick, and lowering the allocation to U.S. stocks if U.S. stocks rise and raising the allocation to U.S. stocks if they fall.

Based on the S&P 500 Forward EPS data published by Fact Set for each quarter since the fourth quarter of 1988, I calculated the simulated points of the Fed model and then compared them to the actual points of the S&P 500 (see chart below).

As you can see from the chart, since the 2008 global financial crisis, the difference between the actual S&P 500 and the Fed Model’s “fair point” has become larger and larger, mainly because the Fed’s implementation of unconventional monetary policies such as 0 interest rates and QE has greatly depressed Treasury yields, which are extremely low. In turn, this has led to an increasing deviation between the model and the actual U.S. stock point.

However, with the rapid rise in medium and long-term U.S. Treasury yields since 2022, the S&P 500 now appears to be trending back to the “fair point” indicated by the Fed Model. According to the current Forward EPS and 10-year Treasury yield data, the Fed Model’s S&P 500 point should be around 4700.

The second model we use is the Fed Chairman Powell’s “hand-picked” risk premium model.

At the press conference at the end of 2020, a reporter asked if it was a bubble that U.S. stocks were raising so rapidly in the face of a raging epidemic. Federal Reserve Chairman Jerome Powell replied.

“If you look at the P/E ratio, its high compared to historical levels, but in a world where risk-free rates will continue to be low, you need to look at the equity premium, which is the return you get for taking equity risk.”

Powell’s point, in fact, was that a reasonable price for U.S. stocks should be determined by a combination of (Treasury yield + equity risk premium), and although U.S. stock prices looked high at the time, the equity risk premium (stock market yield – Treasury yield) for U.S. stocks remained at a normal level because of the near-0 Treasury yield, so there was no big bubble in U.S. stocks.

What is the normal level of equity risk premium?

Based on the performance of U.S. stocks over the past 30 years, typically, the current yield of U.S. stocks would be about 2 percentage points above the 10-year Treasury yield, and based on this 2% risk premium, a valuation model for U.S. stocks can be derived as follows.

Risk premium valuation model ≈ current earnings per share (EPS) / (10-year Treasury yield + 2%)

Clearly, for the long term, this model is still relatively close to the U.S. S&P 500 index point overall, except for periods such as the tech bubble, the 2008-2009 global financial crisis, and the 2020 epidemic crisis.

If we follow this risk premium model, a reasonable current S&P 500 point, which should be around 3,700, is still very close to the current point of U.S. stocks.

The third model we use is a simple expected price-to-earnings ratio (Forward PE) valuation model.

According to the valuation of U.S. stocks in the past 30 years, except during the Internet bubble, the 2008 global financial crisis and the 2020 epidemic crisis, because of the sudden drop in EPS and lead to an unusual surge in Forward PE, in the non-crisis period, Forward PE to observe the valuation range of U.S. stocks, basically fell in the 14-22 times range.

In other words, the expected P/E ratio of 17-18 times is the core range of the valuation of U.S. stocks at each stage.

According to the Forward EPS estimates of the S&P 500 for 2023 by many research institutions, the current “fair point” of the S&P 500 should be between 3,900-4,100 points, which are also very close to the current price of U.S. stocks.

The fourth model we use is the Dharma-Darin story-valuation model, which I have described several times.

The narrative story of the S&P 500 is relatively simple; these 500 companies are global leaders and their earnings continue to grow as the dollar credit currency increases, earnings per share will grow at a rate equal to or slightly above the annual growth rate of nominal U.S. GDP, and any recession, if any, will only affect their short-term earnings and not their long-term valuation.



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