S&P 500 Earnings Yield, Fed Model, FOMC Meeting, Year-End Rally

 “Fed Model” fans are familiar with the S&P 500 earnings yield since it is the Fed Model calculation that subtracts the 10-year Treasury yield from the earnings yield of the S&P 500 (calculated by using Thomson’s forward 4-quarter earnings estimate and dividing it by the closing value of the S&P 500) to get a broadly-based market valuation measure that was once cited by Alan Greenspan in the late 1990s as indicative of what he thought was an overvalued stock market. (The speech where Greenspan first referenced the Fed Model was July 1997, per Wikipedia here.)

If we look at the yield on the 10-year Treasury in July 1997 – roughly a 5%-5.25% yield – and the year-end S&P 500 earnings (actual 1997) were $43.50 and in July 1997, the S&P 500 was trading at – let’s call it 925 – the S&P 500 earnings yield was roughly 4.7%, so the Fed Model, with a value of -0.50, was indicating (probably appropriately) in mid-2007 that the S&P 500 was overvalued.

So what’s the point? While ZIRP distorts the Fed Model (think Nikkei and Japanese interest rates), the S&P 500, forward progress by the S&P 500 in my opinion is likely far more dependent on S&P 500 earnings growth than interest rate levels over the next few years (in my opinion).

Looking back at 2013, readers saw a sharp increase in the 10-year Treasury yield to up to 3% by year-end 2013, and the S&P 500 rose 32% on the year.

For me personally, a “normal” yield curve would have a 2% fed funds rate (about flat with long-run core inflation rate) and a 4% 10-year Treasury yield, and even that implies that the short end of the yield curve would be just breakeven with inflation.

The S&P 500 earnings yield as of Friday, December 11th was 6.13%. The yield was above 6% for most of August and September 2015 during the 10% correction.

The last time the S&P 500 earnings yield was 6.12% was November 13th or one month ago, and the S&P 500 rallied from 2,022 to 2,100 to close out November 2015.

The Fed Model is a broad valuation sword, not a timing tool, but it couldn’t help be noted when the S&P 500 earnings yield of 6.13%, versus November’s yield, when the S&P 500 saw a nice rally.

Also, per Bespoke, bullish sentiment per AAII declined to 28.5% this week, the lowest level of optimism since the September 2015 lows.

Look for the year-end rally, possibly to start after Wednesday’s FOMC announcement.

I do expect the FOMC to increase the federal funds rate 25 bps.

S&P 500 By the Numbers

  • The forward 4-quarter estimate as of December 11th was $123.34, down from last week’s $123.49.
  • The P/E ratio on the forward estimate as of Friday was 16(x).
  • The PEG ratio is still negative, but core S&P 500 earnings growth (ex-Energy) assumed at 5%-7% means S&P 500 still has a PEG over 2(x).
  • The S&P 500 earnings yield is 6.13% versus last week’s 5.90%.
  • The y/y growth rate of the forward estimate was -0.71%, the 4th consecutive week of improvement for the forward estimate. Still negative, and I’d like to see it positive.

This coming week, Oracle (NYSE:ORCL) and FedEx (NYSE:FDX) report Wednesday night after the bell, just after the FOMC decision, so the stock’s reaction and the trading of both names on Thursday could be heavily dependent on what both companies say about 2016 after the bell Wednesday. For both FedEx and Oracle, this is their 2nd fiscal quarters of 2016 (ends May 31 for both) and both guided softer with the August 2015 quarter’s results.

Basically, all of the S&P 500 has reported their September 2015 quarters, so with these November quarter ends, we get more input and perspective on a real-time basis.

No question, FDX is a real-time economic barometer, but ORCL is likely the safer of the two stocks right now.

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