The Two Numbers I am Following Closely

by Wayne Ferbert on November 18th, 2013

As I try to figure out whether the US Markets are possibly worth $1800 on the S&P500 and $16,000 on the Dow, I focus on only one statistic: earnings. Because after all: the question is whether it is ‘WORTH’ it!
 
Whether a company(s) is worth a certain value is based on its earnings power. Certainly all of the companies in these indexes are strong on-going corporate entities so their earnings in future will likely look similar to their earnings today.
 
With 95% of the S&P500 companies having already reported for Q3, this quarter will officially set a record for earnings -- both operating earnings and real earnings after one-time adjustments. The quarter is set to come in at $26.92 in operating earnings and $25.04 in real Earnings. Both represent records. And the 12 months ending this quarter will come in at $102.02 and $94.78, respectively. These are also records.
 
These earnings put the record levels for the S&P 500 in perspective. It continues to affirm that these levels in the S&P 500 are not out of line from a multiple on earnings perspective. On a trailing basis, that is around 17x-18x – which is completely in line with historical levels. It is well below the highest levels ever and well higher than the lowest levels ever. It is certainly in-line.
 
So, if you think these earnings levels are sustainable, then you can’t object to owning the US equity markets. Or can you?
 
It is one thing to say the market is priced appropriately. It is another thing to accurately predict how the market will respond in the future. Right now, interest rates are at all time lows and that is pushing money towards risk assets. Think of it like this: with rates so low, investors are willing to accept a lower return for almost every asset class. As a result, the prices are pushed up to generate the lower return premiums.
 
If rates go back up, then the risk premium needs to go up – and prices should correct downward. But will rates go up? And when?
 
Janet Yellen insisted in her testimony that rates had to go back up – but she made it clear she was in no hurry to make that happen. Any economic hiccup and the Fed will have to keep rates low.
 
The economists are very split on when they expect the Taper to begin and the bond buying program to begin its deceleration. Some think it could be December (not many) and many think it is first quarter 2014. Many others have it around mid-year 2014.
 
The economists are even split on how much rates will move. The 10-year Treasury rate has already moved from 1.6% to over 2.6% this year since the Taper discussion was first mentioned by the Fed in May. Some economists have a target for this rate of 3.2% in 2014. Some think it could be as high as 3.7%. Others think the economy will weaken and the Taper will be pushed off further – resulting in little move to the Treasury rates.
 
In the end, I know one thing: the world’s risk-free rate starts with US Treasuries and all expected returns start with the risk free rate as a base to launch. So, any move in Treasuries will change the purchasing dynamic for US Equities in 2014.
 
In the end, you have to have an opinion on what buyers will do when rates go up and you have to have an opinion on when they will go up.
 
Here is my opinion: I think the Taper is still way off as there will be economic challenges in 2014: real challenges to growth and politically created challenges. As a result, I think interest rates will only move modestly in 2014.
 
But in case I am wrong, here is what we are doing: we are trying to move our clients to the short end of the yield curve to avoid interest rate risk in case we are wrong.

And we are setting our collars with fairly tight bounds on both sides: think around +7% on the call side and -7% on the put side – with June 2014 expirations.


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