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“Cause I’m Free Fallin” Tom Petty

February 4, 2013

I had promised to explain why stocks are overvalued today and with the market approaching all time highs and the best January in the market in a couple of decades, this seemed like a particularly good time to warn you of the strong potential for a coming stock market implosion.

First, a few points about stock valuation. While there are a lot of complicated valuation models, at its core, the value of a company’s stock is simply the value of all discounted dividends received over the lifetime of the stock. In other words, if you buy Company X which provides you with a $2.00 per share dividend , and you project that the dividend will grow by 3 percent per year over a 40 year time horizon, then the value of the company stock will be all those future dividends discounted back to today using the risk-free interest rate ( which is usually equal the projected interest rate on short-term US treasuries). Individual stocks are subject to risk which means that individual stock values or prices are lower than this formula because there is great uncertainty around a company’ s future revenues, earnings and hence dividends. Thus,  investors will usually demand to be compensated for such additional “specific risk”. (For more on this topic, see the Investments work of nobel laureate William Sharpe, who also was my favorite professor at Stanford Business School).  Nonetheless, there are three main components that determine value of stocks and hence the price of stock market indices like the Dow Jones Industrials or SP 500:

(1) current dividends per share paid

(2) projected long-term per annum growth rate in dividends paid per share

(3) the interest rate on a “risk free” instrument such as an intermediate-term treasury bond

For most companies and the S&P 500 as a whole, the best predictor of the future dividends growth rate is their earnings growth rate since dividends are generally paid out of earnings per share and the two have tended to grow at about the same rate over time. (e.g. during 1980-2013, SP-500 dividends per share have grown by 5.1% and earnings by 5.5% per annum).

In order to get a read on how the market is currently valuing/pricing the S&P 500, I used a simple spreadsheet to take the earnings and dividends of the S&P 500 and assumed various discount and growth rates. What I found was interesting to say the least, and a compelling picture as to why the market may be substantially overvalued. Using my spreadsheet model, and solving for the current S&P 500 price of 1514  implies a somewhat slower long-term growth rate in dividends per share of about 4% per year (vs. the last 32 years 5.1%) , but also a continued very low 3% per year, long- term discount rate. However, there are several major problems with this implicit “market” assessment.

(1) Risk-Free “Treasury” Interest Rates/ Discount Rates are almost certain to rise substantially over the next few years. As I have noted in many previous posts, the enormous and growing US debt burden and the unprecedented and reckless dollar printing by the Fed will eventually result in much higher US inflation numbers and in even a more significant weakening of the US dollar.  This in turn will force interest rates much higher. In fact, between 1966 and 2001, long-term, risk-free interest rates were almost always above 5 percent and for most years averaged between 6 and 8 percent . Thus, just moving back to more “normal” interest rates would be a huge rise from today’s 3% rates. However, we are likely to see the situation become much worse than that and at least resemble the situation in the late 1970s and early 80s where we had long-term treasury rates between 8 and 16 percent! 

(2) Dividends Per Share and Earnings Per Share are in a Short-Term “Bubble”. Since the 2008-09 financial crisis, most major US companies have managed to reduced their costs significantly thru layoffs and some improvements in productivity and perhaps most importantly, thru reductions in their interest costs as rates have continued to fall. Most of these savings have gone to the bottom line in terms of  higher earnings and particularly dividends. The problem is there is only a limited ability to cut these costs further for S&P 500 companies. Instead, interest costs, health care costs, pension costs, and taxes are all expected to climb significantly. This is hardly a recipe for robust growth in earnings and dividend payouts. In the long run, inflation will increase the underlying costs of goods sold resulting in a profit margin squeeze as well.   

(3) Long Term Economic Growth Will likely be Much Slower Affecting Long Term Earnings and Dividend Growth–The combination of negative demographics (e.g. aging of population affecting consumption patterns negatively as the baby boomers become lower consuming retirees), slow productivity growth, higher federal, state and local taxes and medical costs and slow US population growth, means that economic growth is likely to be signficantly lower than the 3% per year real GDP growth we’ve experienced over the past 3 decades. Notably, even with enormous monetary and fiscal stimulus over the past 4 years, we have only been able to grow US GDP by around 2%. In other words, we may be lucky to see 1-2% GDP growth over the next decade with all the headwinds noted above.

Bottom line: I ran my spreadsheet with lower dividend growth and higher interest/discount rates. Depending on my assumptions, I found the market was worth only about 20-50% of todays levels. This isn’t to say that the market will crash 50-80% tomorrow. There are too many people who have a vested interest in talking the market up and keeping the participants optimistic. As long as market optimism remains high and the Fed can keep interest rates down in the short-term, the market may increase somewhat more and become even more overvalued. However, once we truly see that we are headed into a “stagflation” world and it becomes clearer that the US is in very serious financial shape, I believe we are in for quite a bit of “free fallin’ “. Will it happen by the end of 2013, 2014 or even 2015???  I can’t say BUT I do know that I am not waiting around to find out.

From → Investments

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