August 12, 2016—In the soon-to-be-released August version of the Capital Perspectives presentation, we have redesigned the way our S&P 500 price target is determined to account for the extremely low interest rate environment inspired by central banks. Through this, we have a visual representation of how the financial markets are being influenced by the broad-based efforts of central banks globally. We have generated a range of potential price targets that reflect how the market may respond based on the level of central bank involvement at our future target date.
Before we get into the rationale for our new approach, it is worth spending a few moments reviewing how we generate our estimate. Typically the S&P 500 estimate has been constructed by looking at the forward earnings for the 12 months beginning with our projection point and then using the current market multiple to generate the expected index level. Thus for our June 2017 target price, the earnings we use are the earnings we expect to see over the 12 months from June ‘17 to June ’18. Developing this estimate is fraught with challenges and potential sources of error; the uncertainty is only compounded when also trying to figure out how much the market will pay for those earnings in the future. However, we do know how much the market is willing to pay today for the earnings expected over the next 12 months, so we use that factor to generate our multiple and in the calculation of the future index value.
As we look at current market conditions vs. the past, we see the situation has changed. The market is currently valuing the next 12 months of S&P earnings at more than 17x those earnings. The chart above shows this is an elevated level that has expanded with the recent push to new record highs. Also, the current level is now well above a multiple band between 15.5 and 16 (shaded area) that has served as a “normal” level over the past three years. We have clearly arrived at a crossroads in our analysis.
So what is going on here? Simply put, we believe we are seeing the market being influenced by the efforts of central banks across the globe to inject liquidity into the markets. This is not a new story and it has certainly influenced markets over the past years since quantitative easing was first introduced, but we are reaching a point where these banking institutions are reaching the limits of their effectiveness. We see the limits of what they can do as negative rates are surfacing which may punish the profitability of financial institutions and fund flows are working in many cases in directions that do not help the economies the central bankers are trying to help. This has helped to lower Treasury yields, narrow corporate bond spreads, and creating an appetite for risk assets that provide higher yields, such as higher-yielding equities. Even if they are reaching the limits of what they can do, we don’t believe this support is going away any time soon.
Given this situation, we have revised the chart showing our S&P target to reflect future prices at both 15.5x and 17x our estimated earnings of $135/share. This gives us a price range of between 2093 and 2295. However, given our belief that central banks will remain heavily involved for some time and that positive year-over-year earnings growth will likely return in the fourth quarter of this year, we are placing more of an emphasis on the 2295 number which reflects the higher current PE. We don’t want to lose sight of the fact that 2093 at 15.5x is more reflective of an environment that would feature far less central bank support and a more normal yield curve.
Source: Wilmington Trust Investment Advisors
The message that central banks are providing a premium in our market equivalent to as much as 1.5x forward earnings is an important one made more so by the fact that we are getting to the point where central bank easing policies are having a diminishing impact. This is a story that we will be returning to in the months ahead as it will have a big influence on our approach to financial markets.
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