S&P 500 forward price to earnings ratios are at the highest they've been since the tech bubble. This may lead to the question- are we in a bubble?
One way of valuing the true value of a stock is how much in earnings it will produce in the future. Present earnings are worth more than future earnings. Generally, a discount rate is used, which is based on treasury yields, but at a higher interest rate to compensate for the risk of owning equities.
Historically, the S&P 500 earnings yield has often closely tracked the 10 year treasury yield, because earnings are expected to grow over time, providing further upside potential, whereas treasuries pay a fixed rate.
https://www.yardeni.com/pub/valuationfed.pdf
This hasn't been the case in current years. Currently, the S&P500's forward earnings yield is 4.68%, vs a 1.53% treasury yield.
Contrast this with the '99 tech bubble, where treasury yields were much higher than the S&P500 earnings yield prior to the crash.
The big risk is of course rising treasury yields as the fed tapers, and eventually raises benchmark rates. Rising treasury yields make bonds more attractive relative to current equity prices, which can lead to a decline if earnings aren't growing.
Fortunately, there is a way you can hedge against this risk. During periods of rising interest rates and inflation, "Value" stocks usually outperform "growth" stocks. This is because earnings are discounted based on current interest rates.
Because interest rates are at historical lows, companies like Tesla, Roblox, Rivian, Lucid Motors are valued at extremely high valuations. This is because when you use a discount rate of 1-2%, future earnings are worth very close to present earnings.
With a discount rate of 2%, earnings in 30 years are worth 55% of present earnings. However, if you raise that discount rate to 7% due to higher treasury yields, earnings 30 years from now are worth just 11% of present earnings!
On the contrary, value stocks like Intel are currently very cheap. In this market, no one wants to own "Dinosaur" companies that aren't growing. They would rather own the companies they expect to be bigger in 30 years, like AMD, Nvidia, etc. And with a 1-2% discount rate, the math checks out.
When interest rates rise substantially, if they do, growth stocks that depend on low rates to justify their valuation will get hit HARD, with as much as 80% downside. Value stocks will be hit as well as their future earnings are discounted further, but not nearly to the same extent that growth stocks do, since they have high present earnings.
Personally, my portfolio is tilted very high towards value stocks and profitable stocks. I hold Fidelity Large Cap Value and Fidelity Small Cap value, and Fidelity Real Estate, as well as VYM and VIG as an indirect way to factor tilt towards profitable stocks.
Of course, stocks always carry market risk. A recession can drive a crash due to lower earnings, as it did in 2009, and in 2020. If you are investing for the short term, it may be smart to avoid having too much in equities.
Submitted November 18, 2021 at 11:27AM by skilliard7 https://ift.tt/3oYAUDp
