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Observations on the Market //

The Stock Market Is Declining. Are We Now Staring Into the Abyss?

Written by Greg Denewiler, CFA® // May 19, 2022

“Stocks fall again on Thursday, pushing the S&P 500 to the brink of a bear market.” Thank you, CNBC for reminding me that I am now staring into the abyss. Let us keep it simple here, the market is down 20% from its high on January 1. What has changed since then? The answer is obvious, you don’t need CNBC to tell you that the culprit is inflation. Target (the retail store) reminded us yesterday that the current environment is a challenging one to do business in. Thus, the stock declined by 30% in just two days. Could this be the abyss?

 

What changed yesterday was that nothing has changed, except that we received confirmation that it most likely will take a while for businesses to navigate through this. You would think that interest rates would be moving higher at a faster pace, considering how investors seem to be much more concerned about it now. The 10-year Treasury bond remains at 2.8% which is where it was in April. Investors’ expectations of what one-year interest rates will pay, one year from now, remain at around 3.1%. However, forward interest rates declined yesterday by almost .2%, gold was unchanged, and oil, one of the major inflationary culprits, fell as well. The real world didn’t really change on Wednesday, only investor psychology did. Somebody is wrong here and time will tell if investors are watching too much CNBC, or if inflation is going to be with us longer than most people think. The more important question is – what should you do with all this?

 

Standard & Poor’s has the current earnings estimates for the market at $224 in 2022 and $248 for 2023 ($248 is slightly higher than the estimate that was updated in March). If the economy does continue to grow and earnings do reach $248 in 2023, you should stop reading this right now and start buying. Given those estimates, we are at a valuation that hasn’t been seen in over a decade. But you say: “What about interest rates? Everyone knows that higher interest rates are bad for stock prices (did you not see yesterday)?” I would respond by pointing out that in 1995 the 10-year Treasury’s yield was 6.6% and the market’s P/E ratio was 15.5x. In 1990 the 10-year was at 8% and the market was at a P/E of 15.5x. Now, we are at 15.5x, assuming earnings of $248 a year into the future. We must admit that no one understands how inflation will play out, but what is certain is that earnings will not be exactly $248; they will either be higher or lower. Investors are worried that they will be lower, so let’s consider that.

 

It is easy to now buy a portfolio of dividend growers that earn 2.75%. If 100-years of history is worth anything, we can assume the dividend will grow by 6%/yr over the next decade. If companies are successful, the dividend of the previously mentioned portfolio will reach 4.9% in 2032. Your choice is to buy the guaranteed 2.8% 10-year Treasury or buy the dividends. If we just use simple math, the average dividend will be 3.8% over 10-years of payouts, while the Treasury will stay stuck at 2.75%. You may be thinking another 1% is not that big of a deal, but it is 35% more income in the long run. Additionally, if we conservatively assume that it takes 10-years for the market to recover to its high of 4,790 and again, just using simple math, that is another 20%, or 2% per year, bringing your 3.8% return up to 5.8% annualized. That has more than doubled your return over the Treasury and we haven’t even considered compounding, (which is significant). Even if this is a “lost decade” (stock prices are little changed), the numbers still work.

 

Circling back to the $248 earnings estimate for the market, it doesn’t really matter whether it happens in 2023 or 2025. It is a given that the economy will eventually grow. If it doesn’t, you have much bigger problems to worry about. This is a great time to evaluate whether you are going to worry about next month’s account balance or building your wealth over the next decade. The two cannot coexist, they are two mutually exclusive mindsets. It is always a gift when it takes less money to buy a growing income stream. As Leonardo da Vinci once stated: “Simplicity is the ultimate sophistication.” It is easy, but it’s hard to keep it easy.

Observations on the Market No. 371 – Published May 19, 2022