Starting in the 1960s, capital asset pricing began to shift focus, tying prospective asset returns to
the levels of the risk free rate (91 day T-Bill yield) and the rate of inflation. In broad terms,
equity strategists started tying the rate of earnings capitalization (the market p/e ratio) to the Bill
yield and inflation, with the market p/e ratio set to vary inversely with the levels of short term
interest rates and of inflation. With some empirical foundation, strategists came up with the 'the
rule of 20' which lays out that the market p/e ratio = 20 - the inflation rate. Thus if underlying
inflation is 2%, the SPX should trade for around 18x net per share. There are different sorts of
issues and problems with the formulation, but it has retained significant popularity.
Using a long term trend line, SPX net should be around $135. out through mid - 2018 and the
market should trade around 2430 (18 x $135.). Under this method, the SPX is reasonable or
fairly valued. There is an issue that investors have not fully broached yet. How reasonable is it
to assume that SPX net per share will grow at 6.5% in the years ahead when the top line or sales
growth may struggle to reach 5% and companies have been squeezing cost structures for years
to boost profit margins? This is why a number of well seasoned strategists are warning that in an
era of real growth below the long term average, investors must brace for lower returns.
For a good while this year, investors were not troubled because they saw the Trump / GOP nexus
pushing stimulus plans that would boost top line growth somewhat and lower the corporate
income tax. But Trump's troubles and a GOP that lacks the unity to push stimulus programs
through raises questions about whether SPX earning power will be strong enough to sustain
the 6.5% growth trend for the next several years.
Whatever your strategic approach to the market may be, the preceding three paragraphs offers
good insight into how the Big Money plays the game most of the time.
Attached is the SPX Monthly Chart. Pay careful attention to the continuing positive reading
of the monthly MACD indicator -- It does not whipsaw often.
- Peter Richardson
- Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!