August was not kind in the markets. The S&P 500 is down more than 3% this month, the Nasdaq Composite fell just over 5% and the Dow Jones Industrial Average declined 3%.
Throughout the bull market dating back to 2009, Brian Wesbury the Chief Economist for First Trust was often referred to as the “Perma-Bull”. He remained bullish on stocks throughout the period. With the benefit of hindsight, he was correct. In addition to being a guest on several investing shows such as CNBC and Fox, he produced white papers and was relatively easy to follow. He would say back then that the heart of his analysis was his Capitalized Profits Model. That model takes economy-wide profits (excluding profits or losses generated by the Federal Reserve) quarter by quarter going back nearly seventy years and discounts those profits by the 10-year Treasury Note yield in each of those quarters. Then compares discounted profits in those quarters with current discounted profits. The model puts equal weight on every previous quarter and uses that average to estimate value. From 2009 through the Pandemic, his model consistently showed that the S&P 500 was undervalued. No matter how much the S&P 500 gained, it was always undervalued.
I have been wondering what his model shows now. Monday morning, 8-28-2023, Mr. Wesbury wrote about that very model. Here is what he said:
“At Friday’s close, the 10-year Treasury was yielding 4.24%. Plugging that yield into the model (and assuming profits remain at the same level as they were in the first quarter) suggests a fair value for the S&P 500 of 3,170, substantially lower than the Friday close of 4,406. It’s important to recognize that the Cap Profits Model isn’t a “trading” model. You shouldn’t use it day-to-day; stocks can remain significantly overvalued or undervalued for prolonged periods of time. However, the model can be used to gauge how attractive stocks are relative to normal.
Today, stocks look expensive….. One way to bring fair value up to Friday’s close of 4,406 would be for the 10-year yield to drop to 3.05%. But what do the economy as a whole and profits in particular look like in a scenario with a much lower long-term bond yield? The yield curve would be very deeply inverted and nominal GDP growth would have to be either much slower or expected to slow substantially soon. In turn, that would probably mean weaker profits.
Another way for the model to project a fair value for stocks at 4,406 would be for profits to rise 39% while the 10-year holds around 4.24%. What makes this absurd is that a world in which profits surge 39% is one where the 10-year yield is almost certainly higher, because nominal GDP growth is much higher as well. Between the end of 2019 (pre-COVID) and Q1(2023) profits are already up 24%. Another 39% gain would put profits relative to GDP well above where they’ve been during the entire post-World War II era.
So, if a large drop in the Treasury yield would likely come with recession and lower earnings, and a sharp increase in profits would likely mean higher long-term interest rates, the market is stuck at current levels. And this, in our opinion, leaves only one main mechanism to bring actual stock prices and fair value back toward alignment: a drop in equity values.
Again, don’t use the model as a reason to sell all your stocks today; that would be foolish. Investors should be focused on their long-term goals and their appetite for risk. The model tells investors they should be at least a little wary and should allocate to sectors that are cheap relative to the market. Allocation is always important, and doubly so under conditions like these.”
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