Post-July 2024 Fed Meeting

FedScope, Vol. 24 No. 8

By: Thomas Rizzo

Fed Meeting Decision

During the July 31st, 2024, Fed meeting, the Federal Open Market Committee (FOMC) kept the target federal funds rate unchanged at 5.25% – 5.50%. Federal Reserve Chair Jerome Powell put the possibility of an initial September rate cut on the table. During the meeting Powell mentioned, “We’re getting closer to the point at which it’ll be appropriate to reduce our policy rate”, after citing that greater progress towards lower inflation as well as a cooler job market no longer threaten to overheat the economy.

Monetary Policy Cycle Timeline

The Fed has kept the federal funds rate at a 23-year high of 5.25% – 5.50% since July 2023, after an aggressive series of hikes that began in March 2022. The potential close of this cycle of contractionary monetary policy comes on the back of promising economic data, providing a level of confidence that the tools that the Fed has implemented to fight inflation have worked. The economy has remained resilient, inflation has cooled, and the labor market has remained strong with subtle signs of cooling prior to the Fed meeting.

Future of Monetary Policy

Following the Fed meeting, on August 2nd, the July Jobs Report was released, indicating a weaker than expected labor market showing signs of slowed hiring with unemployment climbing to a 3 year high of 4.3%. Market participants are pricing in a 100% probability of the first rate cut occurring in September, that after the July Jobs Report is projected to be a 50 basis point cut based on market data.

Given the commentary from the July Fed meeting along with recent economic data, the conversation has changed from trying to determine when we should expect initial rate cuts, to trying to determine how many we should expect by year end. Taking a deeper dive into the probabilities below, you find that the market is fully pricing in consecutive rate cuts for each of the next 3 Fed meetings. These rate cuts may take the form of either 25 or 50 basis point cuts, cutting the federal funds target rate from a 23-year high of 5.25% – 5.50% to 4.00% – 4.25% in December.

Key Takeaways:

  1. After an aggressive series of rate hikes, the economy is showing signs of progress towards the Fed’s policy objectives.
  2. A weak July Jobs Report following the Fed meeting drove the market to price in a 50 basis point cut for the September Fed meeting.
  3. For the remainder of the year, the market has also priced in the possibility of a second 50 basis point cut in November followed by a 25 basis point cut in December.
  4. The target federal funds rate is projected to be cut from 5.25% – 5.50% to 4.00% – 4.25% in December.

Pre-July 2024 Fed Meeting

FedScope, Vol. 24 No. 7

By: Thomas Rizzo

US Economy:

  • Inflation
    • The Consumer Price Index (CPI), a key inflation gauge, rose 3.0% year over year in June, down from 3.3% in May.
  • Economic Growth:
    • Real Gross Domestic Product (GDP), increased at a 2.8% annual rate in the second quarter of 2024, which was greater than the 2.1% expected.
  • Labor Market:

Monthly job growth remains strong, unemployment has increased to 4.1% in June, and job openings have fallen slightly to 8.2 million.

    • Pre-July 2024 Fed Meeting

Looking at market data presented above, as indicated by Fed futures, market participants are pricing in a 100% probability of the first rate cut occurring in September. With rate cuts beginning in September, the door opens for the possibility of 2 rate cuts this year. Overall, in comparison to after the June 2024 Fed Meeting, market participants have been pricing in higher probabilities across the board (with exception to July) for rate cuts this year. Commentary later today for the July 31th Fed Meeting will clarify how many rate cuts we should expect for the rest of the year.

Key Takeaways:

  1. Headline inflation has cooled down to 3.0% after a hot start to the year.
  2. Economic growth has remained strong, exceeding expectations.
  3. The labor market is strong but showing signs of potentially slowing down.
  4. Market participants are pricing in initial rate cuts to begin in September.
  5. Additional Fed commentary will clarify whether we should expect only 1 or 2 rate cuts this year.

Bonjour! 2024 Summer Olympics Begin in Paris, Peacock Looks to Rebound

By: Brent Shockley, Principal


Bonjour! 2024 Summer Olympics Begin In Paris, Peacock Looks To Rebound

The 2024 Summer Olympic games officially begin today and run through Sunday, August 11thThe opening ceremony will feature over 10,000 athletes aboard over 90 boats floating down the Seine River in Paris at 7:30pm local time and 1:30pm Eastern US time.  A few sports, such as football (soccer in the US), got an early start to their opening rounds on Wednesday, July 24th

A study by Oxford University found that nearly every Olympics since 1960 has gone over budget, by an average of 172%. The cost of the 2024 Paris games is expected to be approximately $10 billion, roughly 25% over its original budget.  However, this cost is well below recent Olympics.

Bonjour! 2024 Summer Olympics Begin In Paris, Peacock Looks To Rebound

The difference is largely due to event specific construction.  Unlike many host cities, 90% of the venues in the Paris Olympics are pre-existing.  The major capital expenditures include $1.6 billion for the Olympic Village, $190 million for the aquatics center, and $150 million for gymnastics and badminton. Los Angeles is utilizing a similar strategy to limit spending, along with private funding, to meet its ambitious budget of $6.8 billion for the 2028 Summer Games. 

The 2024 Olympic Games will be broadcast in the U.S. on NBC, its Peacock streaming service, and Telemundo. In 2014, NBC Universal signed an extension with the International Olympic Committee (IOC) to broadcast six Olympic games from 2021 through 2032 for $7.75 billion. NBC executives hope the 2024 Olympic games reverse the decline in Peacock subscriptions, despite recent price increases of $20 for annual plans and $2 for monthly plans. 

Peacock subscribers increased from 4 million in mid-2021 to 33.5 million during the first quarter of 2024.  However, in the second quarter of 2024, Peacock experienced its first quarterly decline losing 500,000 subscribers.  Peacock will stream weekly college football games as part of the Big Ten Conference’s new media package this fall.  In addition to Big Ten games, six Notre Dame football home games will stream on Peacock simultaneously with the linear NBC national broadcast.  Peacock will be the exclusive outlet for Notre Dame’s home game with Louisville on September 28thThe controversial move by the NFL to grant Peacock exclusivity to a playoff game last January (featuring eventual Super Bowl champion Kansas City Chiefs) angered many football (and Taylor Swift) fans but resulted in an average of 23 million viewers, the largest live streaming event in the U.S. Peacock also has the exclusive rights to Green Bay Packers vs. the Philadelphia Eagles in Brazil on Friday, September 6th.  With these strategic additions to its streaming lineup, Peacock aims to regain momentum and attract a broader audience in the competitive streaming market.

Formula 1 in Las Vegas: The Race That Hopes You Don’t Sleep

Formula 1 in Las Vegas: The Race That Hopes You Don’t Sleep

Brent Shockley, Director at ValueScope

November 17, 2023 

Formula 1 In Las VegasFormula One/1 racing returns to Las Vegas this weekend for the first time in over 40 years.  The Heineken Silver Las Vegas Grand Prix 2023 is the start of a three-year contract with the city; although Formula 1 intends to support the race for at least 10 years and the entertainment and gaming hub of the U.S. intends on a “lifetime partnership” with the top class of international racing.  The nearly four mile track will wind through Las Vegas landmarks, hotels, and casinos with a straightaway section down the famous “Strip” at speeds reaching 212 miles per hour in cars that can range in cost from $12 to $20 million.  The Las Vegas Grand Prix is the next to last F1 race on the 2023 circuit.

The race promises to be a visual spectacle….for those in the U.S. that stay up to watch the event.  The Las Vegas Grand Prix will start at 10pm Pacific time on Saturday night, which is midnight or 1am for half of the U.S.  Typical F1 races are designed for 90 minutes but can often go up to two hours with delays.  To prep the drivers, practice runs are set for late Thursday and Friday evening with qualifying from 12am to 1am local Vegas time on Saturday ‘morning.’

The two F1 races in the U.S. this year (Miami and Austin) started in the mid-afternoon local time but this race was set later for the nighttime atmosphere of Las Vegas Strip and to appeal to international viewership, which greatly exceeds that of the U.S.  Global viewership for F1 races averaged 70 million in 2022.  By comparison, U.S. viewership averaged just over 1 million.  F1 interest in the U.S. has seen a significant increase since the debut of the Netflix series “Drive to Survive” in 2019.  Average U.S. viewership of F1 races jumped about 545,000 in 2017 and 2018 to 672,000 to 949,000 in 2021 and 1.2 million in 2022.

Formula One Group, founded in 1950, was purchased for $4.4 billion in 2016 by Liberty Media.  It operates as subsidiary of Liberty under the Nasdaq ticker FWON.K.  The subsidiary reports $2.8 billion of annual revenue and $560 million of EBITDA.  It’s current market capitalization is approximately $15 billion.  It is reported Liberty Media spent between $400 million to $500 million to stage the race, which included $240 million for a purchase of 39 acres on the northeast corner of Harmon Avenue and Koval Lane for the construction of part of the track and a three-story, 300,000 square foot paddock building constructed in less than a year.   The building is a permanent structure as the hub for future F1 races.

Despite the marketing hype beyond any Vegas headliner show or prior sporting event, preparations and demand for the race have hit a speed bump.  Locals, tourists, hotels, and businesses along the Las Vegas Strip have been frustrated throughout 2023 by construction to turn one of the World’s most famous streets into a racing circuit.  Hotels and casinos initially sold high priced ‘experiences’ in the thousands of dollars to include parties with A list entertainers, celebrity chefs and club type accommodations to view the race.  Joe Pompliano reports hundreds of private jets are set to descend upon Las Vegas paying overnight parking fees of $1,500 to $7,500 per night.   However, as the green light gets closer, general ticket sales have been disappointing, with prices dropping by 60% and hotels slashing room rates by up to 80%.

The city of Las Vegas continues to add major sporting events to its list of entertainment options and attractions.  The $2 billion Allegiant Stadium opened in 2020 as the home of the NFL’s Raiders franchise and will host Super Bowl LVIII in February 2024.  The Vegas Golden Knights, founded in 2017, are the defending National Hockey League champs.  The Las Vegas Aces are back to back WNBA champions and the city is host to part of the NBA’s Summer League. On Thursday, Major League Baseball owners approved the relocation of the A’s franchise from Oakland to Las Vegas.  A new baseball stadium along the Las Vegas strip is expected to be ready for the 2028 baseball season.  The city had no major sports franchises prior to 2017.

*The ValueSport blog is a look at the hybrid world of sports and business.  It is published by the professionals at ValueScope, a leading business valuation and advisory firm headquartered in the Dallas-Ft. Worth area.

Disney PENN & ESPN Bet

Disney and PENN Entertainment Team Up to Launch ESPN Bet

Disney PENN & ESPN Bet
Disney Penn &Amp; Espn BetPenn Entertainment (Nasdaq: PENN) has rebranded its online sportsbook with a 10-year, $2 billion licensing deal with ESPN. The new look mobile app and website launches today, November 14th, and is available in 17 states including Arizona, Colorado, Illinois, Iowa, Indiana, Kansas, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, New Jersey, Ohio, Pennsylvania, Tennessee, Virginia, and West Virginia. The state of Nevada is noticeably absent due to the state’s requirement for in person registration at a participating casino and ties to some of the biggest brands on the Las Vegas strip such as MGM, Caesars, and Wynn, each with their own sports betting apps. ESPN Bet is a bold endeavor for PENN to gain market share from industry leaders DraftKings (39%) and FanDuel (31%). PENN currently has only 2% of the legalized online betting in the U.S. but believes licensing the ESPN brand will allow it to reach its 20% market share target by 2027. It’s been a rough 2023 for PENN in the gambling space. Earlier this year, PENN acquired the remaining 64% stake in Barstool Sports for $405 million. PENN purchased a minority 36% stake in the Barstool in 2020 for $163 million. However, the acquisition of Barstool in February turned negative quickly as PENN was denied gaming licenses attributed to the controversial and polarizing content and personalities of Barstool Sports. As a result, PENN was compelled to sell Barstool back to founder Dave Portnoy for $1.00 in August, just months after the acquisition of the company. PENN reported a loss of disposal of Barstool in the amount of $923 million in its latest 10-Q, which included $715 million of goodwill and intangible write offs. The sale back to Portnoy included the right to 50% of any future sale of Barstool; although, Mr. Portnoy claims he will ‘never’ sell the company again. ESPN is diving deeper into the world of sports betting after strategically incorporating more betting odds and information into its broadcast content in recent years. The ‘worldwide leader in sports’ rebranded its Daily Wager show to ESPN Bet Live in September and moved its studio to ESPN headquarters in Bristol, Connecticut after three years at the LINQ Hotel on the Las Vegas strip. The LINQ residency was a partnership between Caesars Entertainment (owner of the LINQ) and ESPN. Now that ESPN has joined forces with PENN, it was time for a split and change of venue. Although there are concerns about ESPN’s sports broadcasting rights and its new venture into sports betting, the Disney owned company has placed wagering restrictions on select employees that could learn inside information as part of their coverage. The increasing commercial interest in U.S. sports betting is a result of the Supreme Court overturning the Professional and Amateur Sports Protection Act (PASPA) in 2018. The PASPA previously prohibited sports betting outside of the state of Nevada. Earlier this month, DraftKings reported revenue for the third quarter increased 57% to $790 million. Online sports betting revenue in the U.S. is expected to reach $7.6 billion in 2023 with projections to increase to $14.4 billion by 2027.

The Value of X

X Valuation Twitter ValuationThe Value of X

X, formerly Twitter, is now valued at $19 billion, according to the company’s employee equity compensation plan. This is a significant drop from the $44 billion that Elon Musk paid to acquire the company in October 2022.

Several factors may have contributed to the valuation drop.

  • The overall economic slowdown: The tech sector has been particularly hard hit by the recent economic downturn, and X is no exception. The company’s revenue growth has slowed in recent quarters, and it has struggled to keep up with its competitors.
  • Musk’s erratic leadership style: Musk is known for his impulsive decision-making and his habit of publicly criticizing his employees. This has led to uncertainty and instability at X, and it has made it difficult for the company to attract and retain top talent.
  • Musk’s plans for the company: Musk has said that he wants to make X a more open and freer platform for speech. However, this has raised concerns among some users and advertisers, who worry that the platform will become more toxic and less welcoming.
  • The dropping of the Twitter brand name In October 2023, Musk announced that X was dropping the Twitter brand name. This decision was met with mixed reactions, with some users and analysts arguing that it was a mistake to abandon a well-known and established brand.

X may need to take a lesson from its peer group of Fortune 500 companies. In the past, companies have faced repercussions for similar actions like Musk’s recent leadership decisions.

Blackberry, the once dominant player in the smartphone market, failed to adapt to the evolution of touchscreen technology and app ecosystem in favor of physical keyboards and its web browser. BB ignored consumer interest in cameras and social media integration and convenience. The company once controlled about 20% of the smartphone market in 2010 with a market capitalization of $40 billion.  Three years later, the market share dropped to 0.6%, and the market cap fell to $4 billion.  In 2016, the company stopped making phones and discontinued tech support on its classic smartphones in January 2022.

The Coca-Cola Company introduced a new recipe in April 1985 and immediately created a consumer backlash that caused the company to restore the original formula as Coca-Coca Classic in July 1985. 20th Century Fox convinced George Lucas to take a $20,000 pay cut on the original Star Wars in exchange for all merchandising rights to film and all its sequels: the deal cost Fox billions. Blockbuster declined an offer in 2000 from Netflix co-founder Reed Hastings to publicize Netflix in their stores.  Ten years later, Blockbuster filed for Chapter 11 bankruptcy, and Netflix is now worth nearly $180 billion. Ross Perot and his company, Electronic Data Systems, passed on an offer to purchase Microsoft for $40-60 million in 1979. Currently, Microsoft is worth $2.5 trillion. Quaker Oats purchased the Snapple fruit drink brand for $1.7 billion in 1993, which was widely considered overvalued. Just over two years later, Snapple was sold for only $300 million, resulting in a loss of $1.4 billion.

The dropping of the Twitter brand name is likely to have had a negative impact on the company’s valuation. A brand name is a valuable asset, and it represents the company’s reputation and goodwill. By dropping the Twitter brand name, Musk is essentially starting over from scratch, and he will need to invest heavily in building brand awareness for X. Additionally, the dropping of the Twitter brand name may have alienated some users and advertisers. Twitter is a well-known and established platform, and many users and advertisers are familiar with the brand. By dropping the Twitter brand name, Musk is taking a risk that he will lose some of this valuable customer base.

Overall, the valuation drop of X is a sign of the challenges that the company is facing. Musk has a lot of work to do to turn the company around, and it remains to be seen whether he will be successful.

(value of x, value of twitter, business valuation of x, business valuation of twitter)

The Relationship Between S&P 500 P/E Ratios and US Interest Rates

Download the white paper here.

As a follow up to our more comprehensive 2017 paper and 2018 paper, this paper will strictly focus on the historical and current relationship between the S&P 500 P/E Ratio and US Interest Rates, updated to November 2022.

The P/E ratio can be described as the ratio between current share price and per-share earnings.  Earnings in the S&P 500 are calculated using the 12-month earnings per share of “current” earnings.  A higher P/E ratio suggests that investors expect higher earnings growth in the future.

During the period January 1971 to November 2022, the S&P 500 P/E ratio averaged 19.9x, while the median S&P 500 P/E ratio was 18.3x.[1]  The S&P 500 P/E ratio as of November 16, 2022 was 20.6x, which is slightly higher than the historical average of 19.9x.[2]  This ratio is currently in the 62nd percentile of the historical distribution.

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

It is important to understand that returns can be estimated as changes in the P/E ratio and changes in earnings; therefore, factors that drive changes in the P/E ratio will also drive stock returns.

P/E ratios have demonstrated an inverse relationship to interest rates.  Given recent interest rate hikes and expectations for the Federal Reserve to continue to increase rates, at least in the short-term, P/E ratios are likely to decline.

However, only 22.4% of the variability in P/E ratios can be explained by the regression with interest rates, where interest rates (i) are the independent variable and P/E ratios are the dependent variable.

When we test the current federal funds rate of 3.83%, our equation predicts an S&P 500 P/E ratio of 21.5x – very close to the current P/E ratio.

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

[1]      Based on monthly data from multpl.com.

[2]      July 2022 through November 2022 P/E ratios are estimates.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

If you liked this blog you may enjoy reading some of our other blogs here.

Economic Overview – Third Quarter 2019

U.S. Economic Report – September 30, 2019

During the second quarter of 2019, the U.S. economy grew at an annual rate of 2.0% over the prior quarter.  Household spending has been a primary driver of growth, and the economy continues to perform strongly despite slowing global growth and headwinds from trade disputes.

Overview of the U.S. Economy

According to the third estimate released by the Bureau of Economic Analysis (BEA), the U.S. economy grew in the second quarter of 2019, with real gross domestic product (GDP) increasing at an annual rate of 2.0%, following a first quarter increase of 3.1%.  The increase in real GDP in the second quarter reflected positive contributions from PCE, federal government spending, and state and local government spending that were partly offset by the negative effects from private inventory investment, exports, nonresidential fixed investment, and residential fixed investment [1].  This brings the US economy its twenty-first consecutive quarter with positive GDP growth.  For comparison, the longest streak of consecutive quarters is thirty-nine, which occurred between 1991 and 2001.

Economic Overview Third Quarter 2019

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, a 1.8% annual real growth rate for the third quarter of 2019 and 2.0% for the fourth quarter of 2019.  The forecasters predicted, on average, that real GDP will grow 2.3% in 2019, 1.9% in 2020, 2.0% in 2021, and 2.1% in 2022.  The forecast for 2021 was higher than previous estimates, while the forecasts for 2019, 2020, and 2022 were revised downward from previous estimates [2].

Population

Population growth is an important driver of long-term growth in an economy.  The total population increased from 327.7 million in August 2018 to 329.7 million in August 2019 [3].  The working age population (15-64) declined slightly from 206.6 million in August 2018 to 206.2 million in August 2019 [4].

Economic Overview - Third Quarter 2019

The labor force participation rate has hardly budged in recent years and remains lower than pre-2008 levels.  In August 2019, the civilian labor force participation rate was 63.2% [5].  The minimum participation rate in the past decade was 62.4%, recorded in September 2015, while the maximum of 66.4% was recorded in December 2006.  This is at least partially explained by the aging population but could be evidence of slack in the labor market.

Economic Overview - Third Quarter 2019

Employment

Nonfarm payroll employment, according to the Bureau of Labor Statistics (BLS), rose by 130,000 in August 2019.  The unemployment rate (U3) in August 2019 remained at 3.7%.  This is at the bottom end of the Federal Open Market Committee (FOMC) participants’ projections of the long-run natural rate of unemployment, which range from 3.6% to 4.5%.  The BLS reported job gains in federal government, health care, and financial activities [6].

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, that the unemployment rate will be 3.7% in 2019, 3.6% in 2020, 3.9% in 2021, and 4.0% in 2022 [7].

The U6 unemployment rate, which includes all marginally attached workers and those employed part-time for economic reasons, declined from 7.4% in August 2018 to 7.2% in August 2019 [8].  The gap between U3 and U6 has declined from the 10-year high of 7.4% in September 2011 to 3.5% in August 2019.

Economic Overview - Third Quarter 2019

The average number of weeks unemployed has declined to near pre-2008 levels and has decreased over the past twelve months, from 22.6 weeks in August 2018 to 22.1 in August 2019 [9].  This is far below the 10-year high of 40.7 weeks in July 2011 and slightly above the low of 16.5 weeks in March 2008.  The number of jobless claims increased slightly, from 214,750 in August 2018 to 215,600 in August 2019 [10].

Economic Overview - Third Quarter 2019

Inflation

According to the BLS, the Consumer Price Index for All Urban Consumers (CPI-U) increased 0.1% in August 2019 on a seasonally adjusted basis.  Over the previous 12 months, the all-items index increased 1.7% before seasonal adjustment [11].  The index for all items less food and energy rose 2.4% for the twelve-month period ending August 2019.  The energy index fell 4.4% over the last year, while the food index increased 1.7%.  The price pressures measure estimates the probability that the personal consumption expenditures price index inflation rate will exceed 2.5% over the next twelve months.  This price pressures measure reported a probability of 2.2% in August 2019, which is below the average of 8.2% over the past two years [12].

Economic Overview - Third Quarter 2019

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, headline CPI inflation to be 1.9% in 2019, 2.0% in 2020, and 2.2% in 2021.  Over the next ten years, forecasters expect CPI inflation to average 2.20% annually [13].

Interest Rates

The interest rate on the three-month Treasury bill decreased from 2.15% as of September 28, 2018 to 1.84% as of September 30, 2019 [14].  The interest rate on the ten-year Treasury note decreased from 3.05% to 1.68% over the same period [15].

Economic Overview - Third Quarter 2019

On September 18, 2019, the Federal Open Market Committee (FOMC) announced their decision to lower the federal funds target range to 1.75 – 2.00%.  The following charts display projections from FOMC participants of the midpoint of the federal funds target range at the end of each calendar year [16].

Economic Overview - Third Quarter 2019

The following table represents the market’s reactions leading up to and following the FOMC meeting.

Economic Overview - Third Quarter 2019

As of September 30, 2019, the yields on Moody’s Aaa-rated corporate bonds and Baa-rated corporate bonds were 3.01% and 3.88%, respectively [17].

The spread between the twenty-year Treasury Bond and the one-year Treasury Bill declined from 0.54% as of September 28, 2018 to 0.19% as of September 30, 2019 [18].  A combination of increasing short-term interest rates from federal funds rate hikes and tempered long-term growth expectations have caused the yield curve to flatten in recent years [19].  The spread between long- and short-maturity Treasury securities have long been used as a predictive measure for future economic performance.  A recent paper from the Federal Reserve showed that the probability of a near-term recession has increased in recent years.  However, when additional information was incorporated into their model, such as the excess bond premium, the component of corporate bond spreads in excess of an estimate of the compensation for expected default losses, the recession probability was significantly lower [20].

Economic Overview - Third Quarter 2019

Corporate Profits

According to the BEA, profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $75.8 billion in the first quarter of 2019 over the first quarter, compared to a decrease of $78.7 billion in the first quarter of 2019 over the fourth quarter of 2018 [21].

Economic Overview - Third Quarter 2019

Stock Markets

The S&P 500 Total Return Index closed at 5,144.1 on September 28, 2018 and closed higher at 5,330.3 on September 30, 2019.  This corresponds to an annual return of 3.6%.  The Dow Jones Industrial Average Total Return Index closed at 58,028.5 on September 28, 2018 and closed higher at 60,471.5 on September 30, 2019.  This corresponds to an annual return of 4.2%.  The NASDAQ Composite Total Return Index closed at 9,322.1 on September 28, 2018 and closed higher at 9,370.9 on September 30, 2019 [22, 23].  This corresponds to an annual return of 0.5%.  In the graph below, the September 28, 2018 values were set to 100. 

Economic Overview - Third Quarter 2019

Construction & Housing Starts

Construction spending and housing starts are two other important indicators for the economy.  Construction spending may indicate the sentiment in real estate markets and the soundness of the economy while housing starts are an alternative indicator of consumer sentiment.  Increases in demand for newly constructed homes can lead to job growth in the construction industry, increased demand for appliances and furniture, and ripple effects throughout the economy.  Housing starts increased from 1.279 million units in August 2018 to 1.364 million units in August 2019 [24].  Construction spending, a seasonally adjusted annual figure, decreased from $1.312 trillion in August 2018 to $1.287 trillion in August 2019 [25].

Economic Overview - Third Quarter 2019

Consumer Confidence

The Conference Board reported that the Consumer Confidence Index declined in September 2019 to 125.1 from 134.2 in August [26].  The index is based on a survey of consumer perceptions of present economic conditions and expectations of future conditions.  The survey is based on a representative sample of 5,000 U.S. households and is considered a leading indicator of future consumer expenditures and economic activity.

The University of Michigan Survey of Consumers reported that the Index of Consumer Sentiment decreased in August 2019 to 89.8, down from 98.4 in July 2019 and 96.2 in August 2018 [27].  The index is based on a survey of consumer perceptions of present economic conditions and expectations of future conditions.  The survey is based on a sample of 500 phone interviews consisting of 50 core questions conducted across the continental U.S.  This is considered a leading indicator of future consumer expenditures and economic activity.

Economic Overview - Third Quarter 2019

In September, the survey focused on the variation in consumer sentiment based on political party affiliation.  The survey results are presented in the following table.

Economic Overview - Third Quarter 2019

Conclusion

In conclusion, the economy performed well in the second quarter of 2019; however, it has shown signs of slowing down.  Economic growth has slowed, and many economists have revised growth expectations downward.  The yield curve remains inverted, with the 10-year Treasury bond falling below the 3-month Treasury bill.  Every recession since the 1960s has been preceded by an inversion of the Treasury yield curve.  Inflation has been modest, and the labor market remains tight with the unemployment rate hovering around the FOMC participants’ projection of the natural rate of unemployment.  Equity markets have rebounded from a dip at the beginning of August 2019.  Consumer sentiment remains optimistic with a wide divergence based on the individual’s political party.

Federal Reserve Chairman Jerome Powell recounted his thoughts on the economy’s performance at post-meeting press conference on September 18, 2019:

The U.S. economy has continued to perform well.  We are into the 11th year of this economic expansion, and the baseline outlook remains favorable. The economy grew at a 2½ percent pace in the first half of the year.  Household spending—supported by a strong job market, rising incomes, and solid consumer confidence—has been the key driver of growth.  In contrast, business investment and exports have weakened amid falling manufacturing output.  The main reasons appear to be slower growth abroad and trade policy developments—two sources of uncertainty that we’ve been monitoring all year.

The following table displays a summary of the economic indicators, their performance over the past year, and whether this is viewed as a positive or negative sign for the economy at large.  The leading, lagging, and coincident indices were obtained from The Conference Board and were measured as of August 2019 [28].

Economic Overview - Third Quarter 2019

[1]      U.S. Department of Commerce, Bureau of Economic Analysis, Gross Domestic Product: Second Quarter 2019 (Third Estimate), September 26, 2019

[2]      Federal Reserve Bank of Philadelphia, Third Quarter 2019 Survey of Professional Forecasters, August 9, 2019

[3]      U.S. Bureau of Economic Analysis, Population [POPTHM], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[4]      Organization for Economic Co-operation and Development, Working Age Population: Aged 15-64: All Persons for the United States [LFWA64TTUSM647N], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[5]      U.S. Bureau of Labor Statistics, Civilian Labor Force Participation Rate [CIVPART], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[6]      United States Department of Labor, Bureau of Labor Statistics, The Employment Situation: August 2019, September 6, 2019

[7]      Federal Reserve Bank of Philadelphia, Third Quarter 2019 Survey of Professional Forecasters, August 9, 2019

[8]      U.S. Bureau of Labor Statistics, Total unemployed, plus all marginally attached workers plus total employed part time for economic reasons [U6RATE], Civilian Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[9]      U.S. Bureau of Labor Statistics, Average (Mean) Duration of Unemployment [UEMPMEAN], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[10]      U.S. Employment and Training Administration, Initial Claims [ICSA], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[11]      United States Department of Labor, Bureau of Labor Statistics, Consumer Price Index: August 2019, September 12, 2019

[12]      Federal Reserve Bank of St. Louis, Price Pressures Measure [STLPPM], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[13]      Federal Reserve Bank of Philadelphia, Third Quarter 2019 Survey of Professional Forecasters, August 9, 2019

[14]      Board of Governors Federal Reserve System, 3-Month Treasury Bill: Secondary Market Rate [DTB3MS], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[15]      Board of Governors Federal Reserve System, 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[16]      Federal Open Market Committee, Summary of Economic Projections, September 18, 2019

[17]      Moody’s, Moody’s Seasoned Aaa Corporate Bond Yield© [DAAA], Moody’s Seasoned Baa Corporate Bond Yield© [DBAA], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[18]      U.S. Department of the Treasury, Daily Treasury Yield Curve Rates, last accessed October 10, 2019

[19]      Johansson, Peter, and Andrew Meldrum (2018). “Predicting Recession Probabilities Using the Slope of the Yield Curve,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, March 1, 2018, https://doi.org/10.17016/2380-7172.2146.

[20]      Gilchrist, S., and E. Zakrajšek (2012), “Credit Spreads and Business Cycle Fluctuations,” American Economic Review 102(4), pp. 1692-1720.

[21]      U.S. Department of Commerce, Bureau of Economic Analysis, Corporate Profits: Second Quarter 2019, September 26, 2019

[22]      Total return indices include returns from both income and capital gains

[23]       S&P Capital IQ Database, last accessed October 10, 2019

[24]      U.S. Census Bureau and U.S. Department of Housing and Urban Development, Housing Starts, New Privately-Owned Housing Units Started [HOUST], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[25]      U.S. Census Bureau, Total Construction Spending, Seasonally Adjusted Annual Rate [TTLCONS], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[26]      The Conference Board, Consumer Confidence Index, September 24, 2019

[27]      University of Michigan, Surveys of Consumers, September 2019

[28]      The Conference Board, The Conference Board Leading Economic Index® (LEI) for the U.S. Remained Unchanged in August, September 19, 2019

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Economic Overview – Fourth Quarter 2018

U.S. Economic Report – December 31, 2018

Economic Overview Fourth Quarter 2018

During the third quarter of 2018, the U.S. economy grew at 3.4% over the prior quarter.  Despite recent turmoil in equities markets, economic indicators point toward continued economic growth.

Overview of the U.S. Economy

According to the third estimate released by the Bureau of Economic Analysis (BEA), the U.S. economy grew in the third quarter of 2018, with real gross domestic product (GDP) increasing at an annual rate of 3.4%, following a second quarter 2018 increase of 4.2%.  The increase in real GDP in the first quarter reflected positive contributions from PCE, private inventory investment, nonresidential fixed investment, federal government spending, and state and local government spending that were partly offset by the negative effects from exports and residential fixed investment.1 This brings the US economy its eighteenth consecutive quarter with positive GDP growth.  For comparison, the longest streak of consecutive quarters is thirty-nine, which occurred between 1991 and 2001. Economic Overview Fourth Quarter 2018.

Economic Overview Fourth Quarter 2018

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, a 2.6% annual real growth rate for the fourth quarter of 2018 and 2.4% for the first quarter of 2019.  The forecasters predicted, on average, that real GDP will grow 2.9% in 2018, 2.7% in 2019, 2.1% in 2020, and 1.7% in 2021.  The forecasts for 2018, 2020, and 2021 are higher than previous estimates, while the forecast for 2019 is lower than previous estimates for the same periods.2

Population

Population growth is an important driver of long-term growth in an economy.  The total population increased from 326.9 million in November 2017 to 329.2 million in November 2018.3  The working age population (15-64) increased from 205.8 million in November 2017 to 206.8 million in November 2018.4

Economic Overview - Fourth Quarter 2018

The labor force participation rate has hardly budged in recent years and remains lower than pre-2008 levels.  In November 2018, the civilian labor force participation rate was 62.9%.5   The minimum participation rate in the past decade was 62.3%, recorded in September 2015, while the maximum of 66.4% was recorded in December 2006.  This is at least partially explained by the aging population but could be evidence of slack in the labor force.

Economic Overview - Fourth Quarter 2018

Employment

Nonfarm payroll employment, according to the Bureau of Labor Statistics (BLS), rose by 155,000 in November 2018.  The unemployment rate (U3) in November 2018 was unchanged at 3.7%.  The BLS reported job gains in health care, manufacturing, and transportation and warehousing.6 This is slightly below the Federal Open Market Committee (FOMC) participants’ projections of the long-run natural rate of unemployment, which have a range of 4.0 to 4.6%.

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, that the unemployment rate will be 3.9% in 2018, 3.7% in 2019, 3.8% in 2020, and 4.0% in 2021.7

The U6 unemployment rate, which includes all marginally attached workers and those employed part-time for economic reasons, has declined from 8.0% in November 2017 to 7.6% in November 2018.  The gap between U3 and U6 has declined from the 10-year high of 7.4% in September 2011 to 3.9% in November 2018.

Economic Overview - Fourth Quarter 2018

The average number of weeks unemployed has declined to near pre-2008 levels, to 21.7 weeks in November 2018, from 25.2 in November 2017.  This is far below the 10-year high of 40.7 weeks in July 2011, and slightly above the 16.5 weeks in March 2008.  The number of jobless claims has also been declining.  For the week ending December 22, the number of seasonally adjusted jobless claims was 216,000, while for the prior year that number was 242,000.8

Economic Overview - Fourth Quarter 2018

Inflation

According to the BLS, inflation, as measured by changes in the Consumer Price Index for All Urban Consumers (CPI-U), was unchanged in November 2018 on a seasonally adjusted basis.  Over the previous 12 months, the all items index increased 2.2% before seasonal adjustment.  The index for all items less food and energy rose 2.2% for the twelve-month period ending November 2018.  The energy index rose 3.1% over the last year, while the food index increased 1.4%.The price pressures measures the probability that the personal consumption expenditures price index inflation rate will exceed 2.5% over the next twelve months.  This price pressures measure reported a probability of 4.9% in December 2018, which is reasonably low relative to the past five years.10

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, headline CPI inflation to be 2.4% in 2018, 2.3% in 2019, and 2.3% in 2020.  Over the next ten years, forecasters expect CPI inflation to average 2.21% annually.11

Economic Overview - Fourth Quarter 2018

Interest Rates

The interest rate on the three-month Treasury bill increased from 1.42% as of January 2, 2018 to 2.40% as of December 31, 2018.12  The interest rate on the ten-year Treasury note increased from 2.46% to 2.69% over the same period.13

Economic Overview - Fourth Quarter 2018

On December 19, 2018 the FOMC announced their decision to increase the federal funds target range from 2.0 – 2.25% to 2.25 – 2.5%.  This increase was anticipated, and the FOMC’s added the following sentence to their official statement:

The Committee judges that risks to the economic outlook are roughly balanced, but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.14

The following charts display projections from FOMC participants of the midpoint of the federal funds target range at the end of each calendar ear, as well as the implied probabilities of the federal funds rate path from federal funds rate futures markets. 15, 16  Most FOMC participants have revised their forecast of the federal funds rate from three rate hikes in 2019 down to two.

Economic Overview - Fourth Quarter 2018

Economic Overview - Fourth Quarter 2018

The following table below represents the market’s reaction during the lead up to and following the FOMC meeting.

Economic Overview - Fourth Quarter 2018

As of December 31, 2018, the yields on Moody’s Aaa-rated corporate bonds and Baa-rated corporate bonds were 3.99% and 5.14%, respectively.17

The spread between the twenty-year and the one-year treasury bills declined from 0.82% as of December 29, 2017 to 0.24% as of December 31, 2018.18  A combination of increasing short-term interest rates from federal funds rate hikes and tempered long-term growth expectations have caused the yield curve to flatten in recent years.  The spread between long- and short-maturity Treasury securities have long been used as a predictive measure for future economic performance.  A recent paper from the Federal Reserve showed that the probability of a near-term recession has increased in recent years.19  However, when additional information was incorporated into their model, such as the excess bond premium,20 the component of corporate bond spreads in excess of an estimate of the compensation for expected default losses, the recession probability was significantly lower.

Economic Overview - Fourth Quarter 2018

Corporate Profits

According to the BEA, profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $78.2 billion in the third quarter of 2018 over the second, compared to an increase of $65.0 billion in the second quarter of 2018 over the first.21

Economic Overview - Fourth Quarter 2018

Stock Markets

The S&P 500 Total Return22 Index closed at 4,672.65 on December 29, 2017 and closed lower at 4,441.63 on December 31, 2018.  This corresponds to an annual return of negative 4.9%.  The Dow Jones Industrial Average Total Return Index closed at 53,317.96 on December 29, 2017 and closed lower at 51,462.77 on September 30, 2018.  This corresponds to an annual return of negative 3.5%.  The NASDAQ Composite Total Return Index closed at 7,935.29 on December 29, 2017 and closed lower at 7,709.91 on December 31, 2018.23  This corresponds to an annual return of negative 2.8%.  In the graph below, the December 29, 2017 values were set to 100.  Each of these indices were near their all-time highs in September.

Economic Overview - Fourth Quarter 2018

Construction & Housing Starts

Construction spending and housing starts are two other important indicators for the economy.  Construction spending may indicate the sentiment in real estate markets and the soundness of the economy, while housing starts are an alternative indicator of consumer sentiment.  Increases in demand for newly-constructed homes can lead to job growth in the construction industry, increased demand for appliances and furniture, and can have a ripple effect throughout the economy.  Housing starts decreased from 1,265 thousand units in October 2017 to 1,217 thousand units in October 2018.24  Construction spending, a seasonally adjusted annual rate, increased from $1,247,531 million in October 2017 to $1,308,848 million in October 2018.25

Economic Overview - Fourth Quarter 2018

Consumer Confidence

The Conference Board reported that the Consumer Confidence Index decreased in December 2018 to 128.1, down from 136.4 in November 2018.26 The index is based on a survey of consumer perceptions of present economic conditions and expectations of future conditions.  The survey is based on a representative sample of 5,000 U.S. households and is considered a leading indicator of future consumer expenditures and economic activity.

The University of Michigan Survey of Consumers reported that the Index of Consumer Sentiment increased in December 2018 to 98.3, up from 97.5 in November 2018 and 95.9 in December 2017.27  However, this is lower than the 10-year high in March 2018 of 101.4.  The index is based on a survey of consumer perceptions of present economic conditions and expectations of future conditions.  The survey is based on a sample of 500 phone interviews consisting of 50 core questions are conducted across the continental U.S.  This is considered a leading indicator of future consumer expenditures and economic activity.

According to Surveys of Consumers chief economist, Richard Curtin, consumers reported more negative than positive news regarding job prospects for the first time in two years.  It is possible that the recent stock market performance influenced the results of recent months and remains to be seen if this is indicative of a long-term trend.

Economic Overview - Fourth Quarter 2018

Conclusion

In conclusion, the economy continued to perform well in the third quarter of 2018, which bodes well for the fourth.  Economic growth continued to exceed expectations, inflation has been modest while unemployment remains low, hovering around FOMC participants’ projections of the natural rate of unemployment.  Equities markets, however, have experienced volatility in recent months, erasing the gains seen over the course of 2018.  Consumer and investor sentiment remain optimistic, despite a recent downward tick.  Threats to the economy include potential ramifications from rising tariffs, the impact of the Federal Reserve’s decision to increase the federal funds rate, and a ripple effect from the declines in the stock market.

Federal Reserve Chairman Jerome Powell recounted his thoughts on the economy’s performance at post-meeting press conference on December 19, 2018:

Since September, the U.S. economy has continued to perform well, roughly in line with our expectations.  The economy has been adding jobs at a pace that will continue bringing the unemployment rate down over time. Wages have moved up for workers across a wide range of occupations—a welcome development.  Inflation has remained low and stable and is ending the year a bit more subdued than most had expected.  Although some American families and communities continue to struggle, and some longer-term economic problems remain, the strong economy is benefiting many Americans.

The following table displays a summary of the economic indicators, their performance over the past year, and whether this is viewed as a positive or negative sign for the economy at large.  The leading, lagging, and coincident indices were obtained from The Conference Board.

Economic Overview - Fourth Quarter 2018

[1] U.S. Department of Commerce, Bureau of Economic Analysis, Gross Domestic Product: Third Quarter 2018 (Third Estimate), December 21, 2018

[2] Federal Reserve Bank of Philadelphia, Third Quarter 2018 Survey of Professional Forecasters, August 10, 2018

[3] U.S. Bureau of Economic Analysis, Population [POPTHM], retrieved from FRED, Federal Reserve Bank of St. Louis, January 2, 2018

[4] Organization for Economic Co-operation and Development, Working Age Population: Aged 15-64: All Persons for the United States [LFWA64TTUSM647N], retrieved from FRED, Federal Reserve Bank of St. Louis, January 2, 2018

[5] U.S. Bureau of Labor Statistics, Civilian Labor Force Participation Rate [CIVPART], retrieved from FRED, Federal Reserve Bank of St. Louis

[6] United States Department of Labor, Bureau of Labor Statistics, The Employment Situation: November 2018, December 7, 2018

[7] Federal Reserve Bank of Philadelphia, Fourth Quarter 2018 Survey of Professional Forecasters, November 13, 2018

[8] United States Department of Labor, Bureau of Labor Statistics, Unemployment Insurance Weekly Claims, December 27, 2018

[9] United States Department of Labor, Bureau of Labor Statistics, Consumer Price Index: November 2018, December 12, 2018

[10] Federal Reserve Bank of St. Louis, Federal Reserve Economic Data, Series: STLPPM, Price Pressures Measure, last accessed January 3, 2019

[11] Federal Reserve Bank of Philadelphia, Fourth Quarter 2018 Survey of Professional Forecasters, November 13, 2018

[12] Federal Reserve Bank of St. Louis, Federal Reserve Economic Data, Series: DTB3MS, 3-Month Treasury Bill: Secondary Market Rate, last accessed January 3, 2019

[13] Federal Reserve Bank of St. Louis, Federal Reserve Economic Data, Series: DGS10, 10-Year Treasury Constant Maturity Rate, last accessed January 3, 2019

[14] Wall Street Journal, Fed Statement Tracker, https://projects.wsj.com/fed-statement-tracker-embed/

[15] Federal Open Market Committee, Summary of Economic Projections, December 19, 2018

[16] Federal Reserve Bank of Atlanta, Market Probability Tracker, last accessed January 3, 2019

[17] Federal Reserve Bank of St. Louis, Federal Reserve Economic Data, Series: DAAA, Moody’s Seasoned Aaa Corporate Bond Yield©, Series: DBAA, Moody’s Seasoned Baa Corporate Bond Yield©, last accessed January 3, 2018

[18] U.S. Department of the Treasury, Daily Treasury Yield Curve Rates, last accessed January 3, 2018

[19] Johansson, Peter, and Andrew Meldrum (2018). “Predicting Recession Probabilities Using the Slope of the Yield Curve,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, March 1, 2018, https://doi.org/10.17016/2380-7172.2146.

[20] Gilchrist, S., and E. Zakrajšek (2012), “Credit Spreads and Business Cycle Fluctuations,” American Economic Review 102(4), pp. 1692-1720.

[21] U.S. Department of Commerce, Bureau of Economic Analysis, Corporate Profits: Third Quarter 2018, December 21, 2018

[22] Total return indices include returns from both income and capital gains

[23] S&P Capital IQ Database, last accessed January 3, 2019

[24] Federal Reserve Bank of St. Louis, Federal Reserve Economic Data, Series: HOUST, Housing Starts, last accessed January 3, 2019

[25] Federal Reserve Bank of St. Louis, Federal Reserve Economic Data, Series: TTLCONS, Total Construction Spending, Seasonally Adjusted Annual Rate, last accessed January 3, 2019

[26] The Conference Board, Consumer Confidence Index, December 27, 2018

[27] University of Michigan, Surveys of Consumers, December 2018

[28] The Conference Board, The Conference Board Leading Economic Index® (LEI) for the U.S. Increased Slightly in November, December 20, 2018

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

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The Relationship Between S&P 500 Returns, Earnings Growth, P/E Expansion, and Interest Rates

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The Relationship Between S&P 500 Returns, Earnings Growth, P/E Expansion, and Interest Rates

The S&P 500 increased from 2,789.80 on January 1, 2018 to 2,924.59 on October 1, 2018, a year-to-date return of 4.83%. As shown in the graph below, this return was fueled by a solid increase in earnings of 9.20% but was partially offset by a contraction of 4.37% in the P/E ratio.

 The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

While S&P 500 returns result from both P/E ratio expansion and increases in earnings, these factors have historically been negatively correlated.  This means that the offsetting effect that we see above holds for monthly data over a longer period of time.  In fact, the relationship for the period January 1970 through October 2018 as determined by linear regression is:

Monthly Increase in Earnings = 0.58% – 27.42% × (Monthly P/E Ratio Expansion)

Based on this regression, a 2% decrease in the P/E Ratio will likely be accompanied by a 1.1% increase in earnings, yielding a negative 0.9% S&P 500 return.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

The graph below illustrates the historical relationship of monthly increases in earnings and monthly P/E Ratio expansion.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

While we see an offsetting effect in monthly P/E ratio expansion and monthly increases in earnings, both factors have contributed to cumulative S&P 500 returns since January 1970.  The index has increased 3,138.4% over this period, while earnings have expanded by 2,037.2% and the P/E ratio has increased by 51.5%.1  If we allocate the multiplicative component of the S&P 500 to earnings expansion and P/E ratio expansion, we find that 97.5% of the cumulative return in the S&P 500 since January 1970 has come from expansion in earnings, while 2.5% of the cumulative return is attributable to the growth in the P/E ratio.  The chart below depicts the cumulative S&P 500 return.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

While S&P returns over long periods of time are attributable to earnings expansion, the variation in monthly returns is primarily explained by changes in the P/E ratio (approx. 62%).  The chart below illustrates the relationship between monthly S&P 500 returns and the monthly percent change in the P/E ratio.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

Historical Distribution of the P/E Ratio

During the period January 1970 to October 2018, the S&P 500 P/E ratio averaged 19.5x. However, for the majority of the period, the P/E ratio was less than the 19.5x average. The P/E ratios had remained above the average for the last 48 months.

During the period January 1987 to October 2018, the P/E ratio averaged 23.5x and the median P/E ratio was 20.5x. In the last 15 years, the average P/E ratio has moved further upwards to 24.5x.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

The S&P 500 P/E ratio as of October 1, 2018 was 23.9x, which is 22.6% higher than the historical average of 19.5x. At the same time, it was trading below the last 15 years average of 24.5x.

Interest Rates Compared to P/E Ratio

From our prior paper2 discussing S&P 500 returns, we know that the P/E ratio is theoretically a function of the long-term growth rate in earnings and the required rate of return.  From January 1970 to October 2018, the Federal Funds Rate averaged 5.23%. At the same time, the S&P P/E ratio averaged 19.5x. From 1973 until the end of 1991, interest rates were almost always above the historical average. Most notably, in 1980 and 1981, the Federal Funds Rate rose to 20.00% on four occasions over the two-year period, the highest interest rate in United States history. However, the Federal Funds Rate has averaged 3.50% since 1986 and for the last 25 years, interest rates have remained below the historical average, plummeting to 0.15% in 2009. For the following seven years, the interest rate remained low and only began to increase in December of 2015 when the Federal Reserve determined that economic growth had stabilized. Due to low interest rates since the great recession, the Federal Funds Rate has averaged 1.34% in the last 15 years. It can be seen that the average interest rates have been falling for a long time and had only recently picked up. With some recent increases, as of October 2018, the Federal Funds Rate was 2.20%.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

It can be observed that the relationship between the P/E ratio and Federal Funds Rate changed during this long period. It appears that the change happened somewhere near 1990. Before August 1987, the P/E ratio and Federal Funds Rate displayed the following logarithmic relationship:

P/E ratio = -6.173 ln (Fed Fund Rate) – 3.6381

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

Alan Greenspan took over as Fed Chairman in August 1987. He supported an easy money policy and started reducing interest rates soon after. With a change in the Fed’s policy, the relationship between the P/E ratio and interest rates changed to a very weak linear relationship.

P/E ratio = 27.292 – 94.08 (Fed Funds Rate)

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

The outliers circled above occurred during recessionary periods. After removing the outliers, the relationship between the P/E Ratio and Federal Funds Rate remains weak, as shown in the chart below.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

Conclusion

Analysts estimate an 80.7% chance of at least one more increase in the Federal Funds Rate3 before the end of the year.  While the prior relationship and financial theory would predict that increasing the Federal Funds Rate would lead to a decline in the P/E ratio through an increase in the required rate of return, our analysis shows that this relationship no longer holds.  In future papers, we will investigate the determinants of the S&P 500 required rate of return by examining the implied equity cost of capital.

1. 3,138.4% = (1 + 2,037.2%) x (1 + 51.5%) – 1

2. https://www.valuescopeinc.com/resources/white-papers/the-sp-500-pe-ratio-a-historical-perspective/

3. CME Group, FedWatch Tool, November 8, 2018

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

 

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