A look at circumstances affecting the outlook for 2015

Robert J. Swartout, The Daily Record Newswire

A colleague of mine recently authored an article titled, “Are interest rates going up in 2015?” In that article he compared the 10-year government debt for a variety of developed nations. The United States’ 10-year Treasury rate was the highest. Couple that with the fact that our economy seems to be leading the rest of the world out of recession and it would suggest that there will be a ceiling on the longer part of the yield curve.

Although the Federal Reserve is expected to begin raising the Fed Funds rate some time in 2015, until there are higher yields elsewhere, the impact of higher short rates will be a flattening of our yield curve rather than a shift up across all maturities. Given the attractive domestic yield and the appreciation of our currency, longer term bonds may have another attractive year in 2015.

On the domestic equity side, the S&P 500 index set a number of new records throughout 2014. Mid-caps and small-caps did not fare as well as the large- and mega-cap domestic indices. From a valuation perspective, the 25 year trailing price-to-earnings ratio for the S&P 500 (P/E) is approximately 15.6.
Currently, the trailing P/E is 16.2, suggesting that the S&P 500 is not significantly overvalued.

The 25-year price-to-book ratio is 2.9, and currently the price-to-book ratio is approximately 2.9. The 25-year historic price-to-cash flow is 11.3 and currently about 11.4. The 25-year historic dividend yield is around 2.1 percent and currently about 1.9 percent. These valuation metrics paint a picture of the current U.S. market (the S&P 500 is representative of large capitalization U.S. companies) as being valued fairly closely to its 25-year averages.

Here is where we believe the U.S. equity market begins to be more compelling as a longer term investment. How has the S&P 500 performed since the end
of 2000? On an annualized basis, the S&P 500 has risen 4.24 percent since 2000.

The past 14 years have been one of the worst performance periods for domestic equities in our history. The decade of the 1930s had a worse annualized performance but that time period also included the Great Depression and the 1939 onset of World War II in Europe. The long run average for the S&P 500 is closer to 9.8 percent per year.

As of 2000 the S&P 500 closed at a price of 1320.28 and had earnings of $54.72. The S&P 500 is currently around 2025 and forecast earnings for 2015 are $123.75. So on a price basis (not including dividends) the S&P 500 is up 53 percent from the beginning of 2000 and earnings are up 126 percent. Including dividends, the S&P 500 is up 86.52 percent and earnings are up 126 percent.

As our economy leads the rest of the world out of recession and we continue to see earnings growth, we would expect that the S&P 500 “reverts to its long-term average return” of just under 10 percent. Furthermore, when our interest rate structure returns to a more historic average, perhaps in 2016 or 2017 as other global economies exit their deflationary economic environments and their government bond yields begin to rise, the P/E ratio will likely expand from 16 to closer to 18, if history is an accurate guide.

Back in May 2013, I authored an article titled “Irrational Exuberance,” playing off of that famous phrase from former Fed Chairman Alan Greenspan.
Chairman Greenspan had introduced a valuation methodology in his semi-annual testimony before Congress that attempted to provide a relative valuation between stocks and bonds. The “earnings yield” is defined as the next 12 months earnings estimate for the S&P 500 index divided by the current level of the S&P 500 index. The current 10-year Treasury note yield is used as a proxy for the bond market.

This valuation, routinely referred to as the “Fed Model,” subtracts the current 10-year U.S. Treasury yield from the earnings yield and produces the Equity Risk Premium (ERP). A positive ERP is generally constructive for equity returns on a relative basis to fixed income returns. As I write this article, the earnings yield is 6.1 percent and the 10-year Treasury yields 1.95 percent producing an ERP of 4.15 percent. This suggests that domestic equities are relatively more attractive than the 10-year Treasury market.

Another way to look at these asset classes is to compare P/E ratios. The forward P/E for the S&P 500 is 16.4 and the P/E for the 10-year Treasury is 1/.0195 or 51.3. The current 10-year Treasury P/E is more than three times the P/E for the S&P 500!

So in conclusion, the U.S. bond yields are not likely to rise significantly until the global government rates begin to offer more competitive yields. Short-term rates may begin to rise this year but the Fed is unlikely to push rates up very far until inflation approaches their 2 percent target rate and the labor market starts to show signs of improving wages and employment.

Equities are considerably cheaper than bonds and are close to many long-term valuation metrics. Equities do have some way to go to “catch up” to their longer term average performance and to keep pace with earnings growth. 2015 could be another year where both bonds and stocks produce positive results, but I would suggest that equities look like the better near-term bargain.


Robert J. Swartout is a vice president at Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; (585) 586-4680.