As we move into 2017, Wall Street appears cautiously optimistic about the chances of the stock market moving higher this year. While the Dow Jones Industrial Average has not yet been able to break up above 20,000, the fact that it has not fallen and retraced all of its December gains is a good sign. If corporate America fails to deliver strong results this earnings season, however, the optimism that currently rules Wall Street could fade.
While the election of Donald Trump in early November certainly sparked the latest move higher in stocks, it wasn't the only driving factor. The economic fundamentals in the United States - like employment and wage growth - had already started to improve in the run-up to the election. However, with the election, expectations for stronger earnings growth increased.
Now that the stock market has made such a strong move higher during the past two months, it's fair to say that the expected stronger earnings have already been priced into the market.
This means they'd better materialize, because if they don't, stock values are likely to drop, and investors can now get decent yields on Treasuries.
Looking for Returns
Investors are always looking for the greatest return with the least amount of risk. Investors typically use Treasuries as a baseline when assessing their investment options. They know that if they buy Treasuries, they will get both a reliable return on their investment and a reliable return of their investment. In other words, there is very little risk involved when buying Treasuries.
While Treasury yields have moved lower for nearly three years straight, the increased inflation expectations with the election of Donald Trump and the recent interest-rate hike made by the Federal Open Market Committee (FOMC) have pushed yields up above their 2015 highs.
Currently, the yield on the 10-year Treasury (TNX) is 2.47% (see Fig. 1).
Fig. 1 - 10-Year Treasury Yield (TNX)
This recent jump in Treasury yields has changed how investors approach riskier investments like stocks.
Investors try not to be foolhardy with these investments. They demand a premium for the increased risk they are taking by putting their money into stocks instead of bonds. This "risk premium" can vary quite a bit depending on market conditions, but it has typically been in the neighborhood of 4% to 5% during the past 15 years.
So, if an investor can earn 2.47% on her money by buying virtually risk-free Treasuries and demands a risk premium of 4% to invest in stocks, then those stocks would have to yield at least 6.47% (2.47% + 4% = 6.47%).
But how do you determine the yield of the stock market?
You look to the earnings yield, which is the earnings the market generates, compared to the price you are paying for those stocks (i.e. the earnings-price, or E/P, ratio).
If you've never heard of the E/P ratio before, you're not alone. But, even if you haven't, it should look at least vaguely familiar. That's because it's the inverse of the price-earnings, or P/E, ratio.
Using the P/E Ratio of the S&P 500 to Find the Earnings Yield
You can determine the current earnings yield of the stock market - as measured by the S&P 500 - by finding the inverse of the S&P 500's current P/E ratio.
For instance, according to multpl.com, the current P/E ratio for the S&P 500 is 25.98 (see Fig. 2).
Fig. 2 - S&P 500 P/E Ratio (Chart courtesy of multpl.com)
Now that you know that, all you have to do is find the inverse of this number to determine the earnings yield on the S&P 500, which in this case is 3.85% (1 / 25.98 = 0.03849). You can also see a graphical representation of this on multpl.com (see Fig. 3).
Fig. 3 - S&P 500 Earnings Yield (Chart courtesy of multpl.com)
Don't Forget the Dividends
Now, we don't want to forget about dividends because they play an extremely important role in your overall profitability in the stock market. According to multpl.com, the dividend yield for the S&P 500 today is 1.99% (see Fig. 4).
Fig. 4 - S&P 500 Dividend Yield (Chart courtesy of multpl.com)
If you add the yield on earnings from the S&P 500 - which is 3.85% - and the yield on dividends from the S&P 500 - which is 1.99% - you get a total yield of 5.84% (3.85 + 1.99 = 5.84).
When you compare this 5.84% return with the 6.47% return an investor would demand if she could earn 2.47% on her money by buying virtually risk-free Treasuries and demanded a risk premium of 4% to invest in stocks, the numbers aren't looking so good. Instead of earning a risk premium of 4%, investors are currently only earning a risk premium of 3.37%.
Typically when you see the risk premium drop like this, it tells you that investors are expecting strong earnings growth in the stock market, which seems to be the case currently. However, if the expected earnings growth doesn't materialize, investors will likely begin to demand a higher risk premium once again.
What If Treasury Yields Continue to Increase?
If the yield on the 10-year Treasury continues to move higher - even if investors are still OK with the lower risk premium they are currently experiencing - it is going to put some downward pressure on the P/E ratio for the S&P 500 - causing stock values to move lower.
How low, you ask? We can back into that number by reversing the calculations we just went through to determine the earnings and dividend yield.
Imagine the 10-year Treasury yield moves from 2.47% to 3% (the high it reached in early 2014), investors are still OK with a 3.37% risk premium and the dividend yield rises slightly to 2%. If that were the case, the earnings yield on the S&P 500 would need to rise to 4.37% (4.37% earnings yield + 2% dividend yield - 3.00% Treasury yield = 3.37% risk premium).
At current levels of earnings, for the S&P 500 to have an earnings yield (E/P) of 4.37%, the S&P 500 would need to have a P/E ratio (which is the inverse of the E/P ratio) of 22.88 (1 / 0.0437 = 22.88).
To move from its current P/E ratio of 25.98 to 22.88, the S&P 500 would have to drop by 12%, or from its current level at ~2,265 to ~1,993 (see Fig. 5).
Fig. 5 - S&P 500 Potential Pullback
A move this large would take the S&P 500 back down to its post-Brexit lows, but with the volatility we've seen in the market during the past few years, that wouldn't be an unreasonable assumption.
Earnings season kicks off next week and, while nobody is expecting to see the growth that could come from potential government reforms - business tax cuts, individual tax cuts, etc. - under the Trump administration showing up in the fourth-quarter numbers for 2016, they are nonetheless looking for strong fourth-quarter numbers and positive, forward-looking guidance.
If the fourth-quarter numbers are strong, that indicates that the underlying economic fundamentals that were gaining strength in the second half of 2016 are still improving, and that will provide a solid foundation from which the market will be able to grow in 2017. If the fourth-quarter numbers are weak, we may start to see some of the optimism for 2017 start to fade.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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