It’s been rough in the markets. Just days after posting its biggest single-day point drop in history, the Dow Jones Industrial Average followed that up with its second biggest single-day point drop in history. That implies two days of 4% or greater drops in the same week. Something like that hasn’t happened since 2011.
Alongside the Dow, the S&P 500 Index and NASDAQ 100 are all in correction territory, off more than 10% from their recent highs. Key technical levels are breaking, with major indices breaking below their 20-, 50-, and 100-day moving averages. The last man standing is the 200-day moving average, and some are afraid that if the indices break below that, this could have an ugly, ugly ending.
Read all the headlines. Qualitatively, this sell-off isn’t too hard to understand. Higher rates are to blame. A piece of good news (record wage growth in the January Jobs Report) has turned into the market’s biggest enemy. Investors are worried about inflation showing up to the party earlier than expected (before the effects of Trump’s tax cuts and stimulus fully materialize). That means more rate hikes, which means higher fixed income yields. That is bad, because higher fixed income yields pressure equity valuations.
All in all, this sell-off is just an equity repricing to an era of higher interest rates.
But in all my reading about this sell-off, I haven’t found anything which quantifies this sell-off. So I did some digging, looked at historical data, cranked some numbers, and eventually made numbers sense of this whole panic.
The takeaway? This sell-off is overdone. Even if Treasury yields rise dramatically, the S&P 500 can finish 2018 above 3,000.
The Numbers Behind The Sell-Off
This sell-off is all about inflation, economic growth, interest rates, Treasury yields, and equity valuations. So let’s look at those numbers over history (all data from multpl.com).
From 1950 to today, nominal GDP growth rates and 10-Year Treasury yields have tracked one another quite closely. If you look at the spread between these two rates, you’ll find that the two are almost always very close.
In that period, nominal GDP growth rates have been roughly 80 basis points higher than corresponding Treasuries. Taking out the abnormal 2009-to-present period, nominal GDP growth has been roughly 90 basis points higher than corresponding Treasuries.
That spread gets wider when nominal GDP growth gets bigger. When nominal GDP growth is above 3%, the average spread from the Treasury yield is 110-120 basis points. Above 4%, the average spread is 130-140 bp. And north of 5%, the average is 160.
Heading into 2018, we are looking at what most economists project will be 3% real GDP growth. Inflation is expected to run around 2% to 2.5%. All together, that gets you to roughly 5.5% nominal GDP growth in 2018.
That implies a 10-Year Treasury yield of somewhere between 3.9% (160 basis points lower, in-line with historical average when GDP is greater than 5%) and 4.4% (110 basis points lower, in-line with historical average when GDP is greater than 3%). The average of those two is 4.15%. I think that is where the 10-year will end up by the end of 2018.
Now, look at the relationship between 10-Year yields and equity valuations. Since 1950, the trailing earnings yield for the S&P 500 has been about 100 basis points above the 10-Year Treasury yield. But that includes really big spreads that existed post-2008 thanks to low interest rates. From 1950 to 2008, when interest rates were “normal”, the earnings yield was, on average, 80 basis points above the corresponding 10-Year Treasury.
That implies that with a 10-Year yield at 4.15%, the corresponding earnings yield by the end of 2018 should be between 4.95% and 5.15%. The average of those two is 5.05%. That corresponds to a trailing price-to-earnings multiple of 19.8.
Yardeni Research expects earnings for the S&P 500 to be $155.26 in 2018. A 19.8 trailing multiple on $155.26 in earnings implies a year-end target for the S&P 500 of nearly 3,100.
Bottom Line on This Market Correction
In the near-term, I can’t really tell you where this market is going. I suggest looking at the technicals. Pay attention to the 200-day moving average. If we bounce off that, that’s a good sign.
In the long-term, I can tell you that barring an unrealistic surge in inflation, this market is far from overvalued. In fact, its undervalued. Even if the 10-Year Treasury yield rises to 4%, history says that a sustainable corresponding earnings yield is essentially 5%. With S&P 500 earnings at $155.26 by year-end, a 5% yield (or 20 multiple) means this market is fairly valued above 3,000 by the end of 2018.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
