Investment Outlook – April 2017

The current equity market is the thirteenth bull market for the S&P 500 since 1928. At 96 months, it is the second longest bull run over the period: the longest, from 1990 to 2000, lasted 120 months and appreciated about 425%. The current market has appreciated “only” about 250%. The bull market in bonds began in the early 1980s when ten year Treasuries were yielding close to 16% and T-Bills were paying over 20%; currently, ten year Treasuries are yielding about 2.5% and 90 day T-Bills are paying .75%. The lowest bond yield in two and a half generations was breached earlier this year at 1.4%. Are we at an inflection point? Have interest rates finally begun their long anticipated reversal? And if interest rates are beginning to rise, can the equity market possibly survive?

WALL STREET
There is a theory, recently expressed in the Wall Street Journal, that low U.S. Treasury yields have provided the support for current valuations in the stock market. At the risk of oversimplification, the argument runs something like this: as long as bond yields are lower than stock dividend yields, income sensitive investors will continue to pour money into the stock market, thereby supporting prices. The dividend yield on the S&P 500 index, until very recently, exceeded the yield on ten year Treasuries. With some of the more recent increases in long term interest rates and the post-Trump run-up in stock prices, this premium has evaporated. According to the argument, the disappearance of the stock yield premium knocks the support out from under the market. There is substantial validity for this argument, particularly during periods of low earnings per share growth (not unlike the experience of the last eight years). But when there is some expectation of growth, or increased awareness of risk, the simple comparison of dividend yields to bond yields loses meaning. The math can get very complicated and highly dependent on estimates and assumptions, but the basic framework for evaluating stock dividend yields, as well as price to earnings ratios (P/Es), relies on three variables: growth, the risk free level of interest rates and risk. Growth is the expected growth rate of earnings or dividends (dividends tend to follow earnings); the risk free rate is usually the interest on U.S. Treasury Bills or Bonds; and risk appears as points added to the risk free rate as compensation for the uncertainty of earnings and dividends. Dividend yields tend to be elevated during periods of very low growth expectations. In such an environment, an increase in interest rates, and/or an increase in perceived risk, elevates the required rate of return on dividends and thereby raises the dividend yield by reducing the price of stocks. However, even in an environment of increasing required rates of return, if growth expectations rise more rapidly than rates, yields will fall and P/Es will rise with increasing prices.

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