September 12, 2023

What Governs Valuations In The Stock Market?

The immutable laws of money within the stock market can be understood via the following vignette, which I crafted in 2022 when inflation, as measured by headline CPI, was nearly 10%.

With inflation at nearly 10%, we could certainly experience a '73-'74, '08-'09 style decline in the stock market. While I don't believe this will happen, it's worth working through the math. Such a scenario is grim, but in virtually every instance in which inflation has hit ~10%, the 10 year treasury note's yield has risen to ~10%. If the 10 year treasury note's yield is at 10%, the p/e on the S&P 500 will be at most 10x (1/10 = earnings yield of 10%. I would have to reach parity with the risk free rate + a little risk premium, so we could see 8-9x p/e on the S&P 500)."

Today, with CPI inflation now nearing 2%, the S&P 500's p/e is about 26x (3.8% yield), largely due to Apple and Microsoft having such lofty valuations presently.

[This little comparative analysis is at the heart of the immutable laws of money in the stock market. There is a constant comparison between what investors can achieve via risk free government bonds (as measured, most notably, by the 10 year treasury note) and what investors can achieve via earnings yield from stocks (as measured by the p/e on the S&P 500 Index). We can invert the p/e (e/p) to make the comparison apples to apples. For instance, if the 10 year yields 5%, the S&P 500 Index Fund will yield ~5% (20x p/e or 1/20 e/p) plus a little "risk premium," which means the actual p/e would most likely be something like 17-18x, which implies a yield of 5.7% at the midpoint.].

As can be seen below, the the cost of credit (as measured by the Fed Funds Rate which correlates strongly to the yield on the 10 year treasury note) has moved in line with inflation throughout the history of American capitalism.

As can be seen above, there's been a very strong correlation between inflation and roughly the 10 year treasury note (which is a proxy for the cost of credit).

If the risk free rate (i.e., cost of credit; 10 yr treasury yield) went to 10%, nobody would buy the S&P 500 (SPY) with an earnings yield of 3-4%, which is where it rests currently.

The earnings yield, or free cash flow yield, of the S&P 500 would need to re-rate to 10-12% (risk free rate + a little risk premium), which implies a p/e of about 7x to 9x, which is about 67% lower than where the S&P 500 trades today.

This would entail the price of S&P 500 declining ~60-70% from here. 26x p/e (3.8% earnings or fcf yield) would go to 10x p/e (10% earnings or fcf yield) whereby it would match the risk free rate approximately.

With these ideas in mind, it can be seen that we do not need a catastrophic financial event for the stock market to decline another 60-70%. The mechanisms of inflation + the cost of credit + the immutable laws of money could create such a decline.

Hopefully all of this was helpful and illustrative of how the stock market works!

[Note that, as of today, inflation has fallen precipitously towards 2%, so, while there's always a threat of a recession, an interest rate-driven decline as I described above is very unlikely as of today.]

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