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Declining Stock Valuations: Four Things to Consider

In the aftermath of the recent stock market volatility, market observers and financial media pundits were quick to attribute causes: fear of the Federal Reserve raising short-term interest rates too high, computerized trends following trading algorithms, an economic slowdown in China, the U.S. economy heading into a recession, Brexit, a slowdown in corporate earnings (just to name a few).

The truth is, we can rarely pinpoint the exact causes of such market volatility.  There could be a combination of reasons why large groups of investors decide to reduce risk in their portfolios, moving assets out of equities into less risky bonds or cash.  In many cases, the fear alone that we feel from seeing an alarming drop in stock prices can be enough to cause us to click the sell button.

Undoubtedly, much of the volatility we are seeing in stock prices are emotionally driven in nature, rather than grounded in some well thought out view of changing fundamentals.  When this happens, there is tendency for stock prices to be “oversold,” driving actual valuations far below what is justified by the fundamental (or intrinsic) values.

But this raises the important question of how fundamental value is calculated for an individual stock or the stock market as a whole?  What are the key variables that we should focus on to offset our natural propensity for fear?

Finance theory says that any asset (real or financial) can be valued by estimating the future cash flows the asset is expected to generate, then discounting each future cash flow by an appropriate rate of interest (the discount rate).  The discount rate should reflect the riskiness of those estimated cash flows.  The higher the risk, the higher the discount rate.  This is called discounted cash flow valuation.

That all sounds well and good in a college finance classroom, but how can ordinary investors take advantage of these insights?  Is there a way to think about stock market valuation at a high level that can keep us from getting too emotional about our investments?

Stock valuation involves the interaction of four variables: (1) the current level of earnings (dividends or free cash flow can also be used), (2) the expected growth rate of those future earnings, (3) the current risk-free rate of interest, and (4) the equity risk premium.  The first two represent the future cash flows and the last two compose the discount rate.  Anything that increases cash flows (variables (1) and (2)) and/or lowers the discount rate (variables (3) and (4)) will increase stock prices.  Conversely, anything that decreases cash flows (variables (1) and (2)) and/or raises the discount rate (variables (3) and (4)) will lower stock prices.

We can skip the actual discounted cash flow calculations and simply focus on the current levels of the four variables to see which of those variables can account for the falling stock valuations we’ve experienced.  First, the absolute level of corporate earnings remains robust, especially incorporating the benefits of the tax legislation last year.

Second, what about the growth rate of future earnings?  Earnings growth rates for S&P 500 companies were about 25% in the first three quarters of 2018.  The latest figures for the fourth quarter are estimated to be below that, but still double-digit.  Estimates for 2019 are for single-digit earnings growth and revenue growth, which is more in line with historical averages.  Thus, earnings growth can’t be totally to blame for the 11% drop in the U.S. stock market (Russell 3000) from since the all-time high set on September 20, 2018.

That leaves the discount rate as the likely suspect for the fall in stock valuations.  The third variable is the risk-free rate, for which we will use the 10-year maturity U.S. treasury note.  The yield on the 10-year treasury was just over 3% at the market high last year, but has declined to a 2.73% level today.  We can thus safely eliminate the third variable as a suspect.

That leaves us with the equity risk premium (ERP) as the likely cause of the sell-off.  What exactly is the ERP?  Think of it as the additional return demanded by investors to switch from a risk-free investment to equities.  According to Professor Aswath Damodaran, an expert on valuation, the historical ERP has averaged 4.19% (1960-2018).  During October of last year when the volatility began, the ERP rose to 5.76% and now stands at 5.96%[i].

Here is a graph showing the annual ERP since 1960:

When the ERP rises, investors demand a higher expected return from stocks compared to the safety of risk-free treasuries.  This raises the discount rate applied to future cash flows, which causes equity valuations to fall.

Is there a silver lining in all this for investors?  If we think future cash flows from corporations are still reasonably healthy and we don’t believe that the Federal Reserve will try to raise rates much further from here, one conclusion to all this would be that stocks have suddenly gotten much cheaper to buy.  In fact, according to FactSet, the forward 12-month price-to-earnings ratio of the S&P 500 has now dropped to 14.1, below its 10-year average of 14.6.[i]

The stock market in 2019 will likely continue to exhibit more volatility than we have been used to seeing in the past couple of years and there’s no telling where the market will end up a year from now.  However, since we believe that the risk of a recession still seems remote given the current state of the U.S. economy, investors should consider keeping their equity exposure in place, rather than selling.

John


John serves as Chief Investment Officer for Coyle Financial Counsel and is responsible for overseeing the investment process. John’s prior experience includes managing institutional fixed-income portfolios for corporations, pension funds, non-profit organizations and foundations at several large, global asset managers. With more than 20 years of institutional investment experience, he is energized by helping individuals understand the role investing plays in meeting their long-term financial goals.

 

www.coylefinancial.com
800-480-7913 | coyle@coylefinancial.com

We value your comments and opinions, but due to regulatory restrictions, we cannot accept comments directly onto our blog.  We welcome your comments via e-mail and look forward to hearing from you.

All information is from sources deemed reliable, but no warranty is made to its accuracy or completeness.   This material is being provided for informational or educational purposes only, and does not take into account the investment objectives or financial situation of any client or prospective client.  The information is not intended as investment advice, and is not a recommendation to buy, sell, or invest in any particular investment or market segment.  Those seeking information regarding their particular investment needs should contact a financial professional.  Coyle, our employees, or our clients, may or may not be invested in any individual securities or market segments discussed in this material.  The opinions expressed were current as of the date of posting, but are subject to change without notice due to market, political, or economic conditions.

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