John Carey, Portfolio Manager
Christopher C. Liu, Portfolio Manager
Michael Jamison, Portfolio Manager
October 22, 2018
The Federal Funds Rate is the means by which the Federal Reserve manages its dual mission of economic growth with low unemployment and a stable rate of inflation. Historically, the Federal Funds Rate has been very similar to the Core CPI in the U.S. For example, the Federal Funds Rate is currently 2.00 to 2.25% and the Core CPI is 2.2%. Using the U.S. inflation rate as a proxy for the Federal Funds Rate, the chart below shows the average Price/Earnings valuation for the S&P 500 for different U.S. inflation rates and the effects of a pick-up in U.S. inflation that we are now experiencing. An increase in the inflation rate from the “sweet spot’ of 0-2% that has transpired since the Financial Crisis and Great Recession to its current 2.2% annualized rate has historically caused the U.S. stock market to sell at a lower average Price/Earnings multiple of 17.2 times rather than the 18.1 times as shown in the chart.
Let’s now turn to the U.S. economy and S&P 500 earnings. The most recent G.D.P. growth reported for Q2 2018 was 4.2%, which is higher than the current unemployment rate of 3.9%. A G.D.P. growth rate higher than the unemployment rate has not occurred since Q1 2016. Strong domestic economic growth is contributing to record S&P 500 earnings that are projected to grow by 27.8% and 24.4% in Q3 and Q4 of this year respectively. Our forecasts for full year S&P 500 earnings are $162 and $178 per share for 2018 and 2019. At its closing price of 2,729.37 on October 11th, the S&P 500 was selling at P/E multiples of 16.84 times and 15.33 times our earnings per share projections for 2018 and 2019 respectively. We highlight that both P/E valuations are below the 17.2 times average for 2-4% inflation since 1950 in the above chart and modestly above or in line with the very long-term historical average of 15.7 times since 1871.
So, where do we go from here? In our opinion, the ongoing S&P 500 earnings per share growth to record levels that we are forecasting for this year and next, coupled with U.S. interest rates that we believe won't spike significantly higher, will enable the U.S. stock market to achieve new all-time-highs over the next 12-18 months. At this point of the U.S. economic recovery and equity market cycle, we believe that the S&P 500 will grind its way gradually higher rather than experience a fast and sharp jump to achieve all-time-highs.
While the media has focused on the market’s all-time-highs and the length of the current bull market, the chart below provides evidence that this bull market has been long but not as strong as some since World War II.
Historically, bull markets end because of one of three economic factors: an unexpected acceleration in inflation, economic recession, or excessive valuation. As outlined above, the S&P 500 is currently not excessively valued and strong domestic economic growth makes a recession unlikely in the near-term. While inflation does pose some risk to this bull market, the current readings indicate that the situation is under control and that the Federal Reserve is normalizing interest rates at a measured and smart pace.
The bottom line is that we recommend our clients remain fully invested in the Equity allocation of their portfolios.