According to the US Bureau of Labor Statistics, the Consumer Price Index of all items increased 3.7% before seasonal adjustment over the twelve months up to the 13th September 2023. Seven days later, on the 20th September, Federal Reserve Board members projected that short term interest rates would stay above 5% for all of 2024. On the 31st of August, the US Treasury issued a two year Note paying interest of 5%. The ability now to achieve a rate more than inflation, which is the desire of many savers, simply by lending to the US government has turned treasuries into a compelling alternative. According to research from Bank of America, investment advisors are now favoring fixed income over equities for the first time in at least six years.

Source: BofA US Equity and US Quant Strategy

Analysts expect earnings for the S&P 500 index next year to be $250, an earnings “yield” of approximately 5.9% on the index’s close of $4,238 as at the 30th September. The 1% difference in the return between the earnings yield of the stock market and what is available for short-term treasury investors is more modest than in previous years. Given this “new” alternative and the additional volatility in shares, we would expect that the earnings yield required by investors should drift upwards over time. This has already happened to some extent: a review of 32 large companies shows that, when compared to January 2022, the group’s earnings have increased and their price earnings multiples have decreased, offering better value than in early 2022. The discounting, or change in multiple, has been most pronounced in the “Magnificent Seven” stocks Apple, Microsoft, Amazon, Nvidia, Google, Tesla & Meta. On average, these shares are trading at 29x 2024 earnings – in late 2021, this group was trading at 53x the next year’s earnings.

In the eight years where interest rates finished between 5% and 6% (1968, 1975, 1986-7, 1995-7, 2000), the average forward earnings “yield” was 6.64%, slightly above today’s earnings yield, but suggesting that the market is perhaps not significantly overvalued by historical standards.

Source: KDT. Bank of America. Note that the 2022 EPS figure was taken from expectations in late 2021/early 2022. By the middle of 2022, the Ukraine war and continued inflation had considerably shifted earnings expectations for the year.

Savita Subramanian is a managing director, global head of Environmental, Social & Governance (ESG) Research and head of US Equity and Quantitative Strategy at Bank of America and based in New York. She has been ranked in the Institutional Investor survey for the last ten years.

In a recent interview, Subramanian highlighted that September’s 4.9% stock market decline is normal by historical standards- 5% declines occur three times a year on average using data going back to the 1920s. She believes that the market is perhaps recalibrating the idea that rates may not be declining any time soon. For her, it is interesting that the best performing sectors recently have been energy and healthcare, which she terms the “stagflationary duo”- higher oil prices benefit energy stocks, whereas healthcare is seen as a defensive sector which remains resilient during economic declines.

Savita feels positive that the stock markets will end the year marginally higher at 4,600. The S&P 500 has basically “bought itself some time to adapt to a higher interest rate environment”. If you look at the companies in the S&P 500, they have dramatically reduced their floating rate debt exposure. Following the financial crisis in 2008, both US homeowners and companies reduced their floating rate risk. 85% of US homeowners have fixed rate long dated mortgages, while 80% of debt on corporate balance sheets is fixed rate. This means that companies have time to adapt to the new higher rate, higher inflation environment. Over the last few years, she has observed companies looking to do more with fewer people – companies have been spending more on automation. This is a key advantage she sees that companies have over bonds – companies have more options relative to long bonds, which are, by definition, a fixed return over a fixed duration.

Over the first quarter of the year, a lot of the larger companies such as Alphabet and Meta, did “what they should have done- admitted that they had overbuilt capacity, downsized their labour forces and cut a lot of costs”. These companies then initiated share buybacks, which pulled the cashflow returns for investors forwards. In a higher interest rate environment, companies that are able to return cash faster to investors may be preferred given the higher rates available on cash.

Subramanian has forecast that the “equal-weighted” S&P 500 index will outperform the S&P 500 index by 5% a year for the next decade. Note – the S&P 500 index is weighted by market capitalization, which means that the largest companies, such as Apple and Microsoft, have a higher weighting in the index and have more of an impact on returns. An “equal-weighted” index would give each company in the S&P 500 index the same impact on returns. Subramanian believes that, ultimately, valuation is the most important driver of long-term returns, and right now the valuations for the equal-weighted benchmark are that much more attractive than the valuations for an index based on market capitalization.

Hendrik Bessembinder calculates that Apple has the greatest lifetime wealth creation (nearly $2.7trillion) of all the stocks of US companies from 1926 to 2022. The company went public in late 1980 and the IPO was banned in Massachusetts because it was deemed to be “overpriced”