On today’s show we are talking about distorted valuations. When you consider risk, I’m seeing what I can only describe as an atmospheric inversion in today’s markets.
Wall Street surged toward new record highs on Thursday, as the S&P 500 briefly topped its February 19 closing high of 6,144.15, extending a nearly $10 trillion rally from the brink of a bear market.
On today’s show I’m going to compare the risk free yield on US Treasuries as a baseline benchmark. In some ways, every other investment could be compared to that benchmark. I’m not going to get into the debate whether the US is going to default on its debt in the next decade or not. For the purpose of today’s discussion let’s take it as a given that the US will meet its debt obligations even if that means expanding the annual deficit and the global debt. We know that will eventually break down, but let’s accept the US Treasury as a foundation for now. The reason I’m proposing that is that the reference for all of these investment returns is the US dollar. If the dollar is in question, then the value of all the other investments that a dollar denominated could be called into question as well. That includes Nvidia, Amazon, Walmart, United Airlines and so on.
So let’s call the risk free rate of return the yield on the US 10 year treasury. Today the market opened at 4.25%, pretty much in lock step with the Fed Funds rate. So whether you buy a 30 T-bill or a 10 year bond, your risk free rate of return today is at 4.25%.
The argument is that if another investment is offering a lower yield, then it is somehow a better investment than the risk free rate of return.
Does that make sense that the S&P 500 index would be more expensive than the risk free rate of return?
--------------
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Episode Transcript
Welcome to the Real Estate Special Podcast, your morning
shot of what's new in the world of real estate investing.
I'm your host, Victor Minash. On today's show, we're talking
about distorted valuations. When you consider risk, I'm
seeing what can only be described as an atmospheric
conversion in today's markets. Wall Street surged towards a new
record high on Thursday as the S&P 500 topped its February 19th
(00:25):
closing of 6144. It's extending a rally of nearly
$10 trillion. Now it seems like the markets
have brushed aside worries over war in the Middle East,
insecurity about oil, President Trump declared A ceasefire, and
now somehow a war that's been raging off and on for 75 years
is magically over. The index gained nearly 1%,
(00:47):
powered by tech giants and a rally in bank stocks after one
of the veteran analysts declaredits game on as long as the
economy avoids a recession. On today's show, I'm going to
compare the risk free yield on U.S.
Treasuries as a baseline benchmark.
In some ways, every other investment could be compared
against that benchmark. I'm not going to get into the
debate as to whether the US is going to default on its debt in
(01:09):
the next decade or not. For the purpose of today's
discussion, let's take it as a given that the US will meet its
debt obligations in even if thatmeans expanding the annual
deficit in the global debt. We know that will eventually
break down, but let's accept theUS Treasury as a foundation for
now. The reason I'm proposing that is
that the reference for all of these investments is the US
dollar. And if the US dollar is in
(01:30):
question, then the value of all those other investments that are
dollar denominated could be called into question as well.
That includes NVIDIA, Amazon, Walmart, United Airlines and so
on. So let's call the risk free rate
of return the yield on the US 10year treasury.
Today the market opened at 4 1/4%, pretty much in lockstep
with the Fed funds rate. So whether you buy a 30 day T
(01:51):
bill or a 10 year bond, your risk free rate of return today
stands at four and a quarter. The argument is that if another
investment is offering a lower yield than somehow it's a better
investment than the risk free rate of return.
So let's look at the price to earnings multiple of the S&P 500
stock index. If you calculate the S&P 500 is
(02:11):
currently trading at 28 times trailing 12 months earnings.
If you calculate the reciprocal of that metric, you get a yield
that is possible. Assuming all of the companies in
the S&P 500 paid out 100% of their earnings to shareholders,
that gives you a possible yield of 3.57%, which is lower than
the 10 year treasury yield. What the market is essentially
(02:32):
saying is that all of those 500 companies that make up the S&P
500 have generated a yield of 3.57% when you look in the
rearview mirror. And somehow that's a better bet
than the risk free rate of return of four and a quarter.
Now I know what you're thinking.You can't just look at the
trailing price to earnings ratio.
You should be looking at the forward price to earnings ratio
for the coming year. That's a forecast of what
earnings will do in each of the 500 companies listed in the S&P
(02:55):
500. The market analysts that
assemble all of these forecasts would put the earnings growth is
pretty substantial. The forward PE for the S&P 500
sits at a lower 22 times earnings, which by the way is
still in the stratosphere compared with history.
If we do the same math again, weget a 4 1/2% yield for all of
the companies in the S&P 500, again assuming they distribute
(03:16):
all of their net income to investors, which of course they
don't. So what the market is saying is
that the equity market is a better bet than the risk free
rate of return of U.S. Treasuries.
You can take an investment in the S&P 500 and it's as good as
cash. It's as good as holding a 10
year U.S. government bond. But let's look at the price to
earnings ratio. Is it possible that the US could
enter a recession at some point in the next couple of years?
(03:39):
If that were to happen, then theforecast increase in earnings
that's assumed in the forward projection price to earnings
ratio would not be accurate any longer.
If earnings remain flat or if earnings fall, then the PE ratio
would be at least as high as thecurrent 28 times earnings or go
even higher if earnings fall. Now we know that U.S.
President has been arguing the tariffs will not be inflationary
(04:01):
and the cost of tariffs will be absorbed by companies and not
passed on to consumers. So if the government is
extracting tariff revenue from the supply chain and consumers
are not going to pay tariffs, then the money can only come
from one place, and that's corporate earnings.
So somebody please explain to meusing any kind of math that adds
up, I don't care if it's simple math or complicated math, how we
(04:21):
will see rising corporate earnings well into next year
that supports the valuations that we're seeing in the S&P 500
index. Some will say that the valuation
is actually being driven by technology and AI.
And yes, I get that. Yes, NVIDIA makes up a
disproportionate share of that value increase in the stock
index, but we now have AMD and IBM and Huawei and Google all
(04:43):
developing their own chips to compete with NVIDIA.
Nvidia's early stranglehold on the market is under assault.
We won't see the impact of that in the next 90 days or even the
next 180 days. But NVIDIA will lose market
share because their existing customers don't want to be
paying the inflated prices to NVIDIA.
That's just a fact. So we know they're going to lose
market share. And yes, I know that NVIDIA is
(05:05):
going to try and compete with their existing customers by
entering the data center business themselves.
Well, the landscape is littered with companies that have died by
competing with their customers. So somebody please explain these
S&P 500 valuations to me becauseI don't get it.
As you think about that, have anawesome rest of your day.
Go make some great things happenand we'll talk to you again
(05:27):
tomorrow.
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