What A Difference One Percentage Point Makes

I believe that the fair value for the S&P 500 Index is a function of normalized current earnings, expected earnings growth, dividend payout, and current interest rates. This is known as a dividend discount model. Theoretically, fair value is the future dividend stream discounted to the present at a rate (the discount rate) which reflects the current level of risk-free interest rates plus an equity risk premium. Faster earnings (dividend) growth and/or a lower discount rate would lead to a higher fair value, and vice versa.

In a posting November 14, 2008 entitled "All In--A Double Entendre", I calculated that, according to this "fair value" approach, the S&P 500 Index should reach the previous high of 1565 sometime in 2016. In that calculation I assumed a 7% annual earnings growth rate, the historical mean price to earnings ratio of 15, and normalized earnings of $64.

It has been my contention that the enormous leveraging of the last quarter century to 350% of GDP will take several years to work off. The consumer normally accounts for 65% of GDP. Juiced by this debt splurge, consumption has now become 70% of GDP. Anyone who has read my postings knows that I am a strong believer in "regression to the norm". It would seem that, at least for several years, consumption will increase at below normal growth to reestablish normal levels. Since consumption constitutes such a large percentage of GDP, there is the possibility that the long-term earnings growth rate of 7% will prove to be less during the next economic cycle--perhaps closer to 6% than 7%.

Historically, often when earnings growth slows, interest rates decline. The lower interest rates imply a higher price to earnings ratio, which tends to offset the negative impact of lower earnings growth on fair value. However, this time interest rates may not decline due to the vast additional Treasury debt required to finance the new stimulus programs. If so, it would be relevant to compare the difference in fair value with a 6% as opposed to a 7% earnings growth rate. According to the dividend discount model. with no change in interest rates, the price to earnings ratio should be closer to 13 than 15. The fair value, say in 2016, with a decline in earnings growth of one percentage point and a lower price to earnings ratio, would be 1251, compared with 1565. From today's S&P 500 Index price of 940, that would mean compound annual appreciation of 4.2% rather than 7.6%. Add in a dividend yield of 2.4%, and the annual total return becomes 6.6% rather than 10% --a huge differential. Or, in other words, rather than reaching the old high of 1565 in 2016, that level wouldn't be reached until 2020.

What is the probability that a 6% earnings growth rate will soon be perceived as the secular norm, replacing the historical 7%?--not likely at least during the economy's early recovery period when the strong positive earnings effect from our economy's operating and financial leverage will mask any change in the secular trend. I decided to undergo this exercise because of the possible very long-term implications. Even then, given Wall Street's proclivity to be bullish, it is doubtful that a lower secular earnings growth rate will become the accepted norm.

I should also mention that the S&P 500 Index departed from fair value in 1995 and stayed overvalued until fourteen years later in March, 2009. I believe strongly that this was primarily due to the enormous influx of baby boomer retirement money into the equity market starting in 1995. Demographics no longer provide a tailwind--quite the contrary, we now have a two-club length wind in our face.