SPY: The Long-Term Case For This Market

If your long-term goal is a comfortable retirement after decades of hard work, then you’re no stranger to the stock market. It’s not the only way to build a nest egg, but it is one of the primary ways, and investing in good ol’ blue-chip stocks is a fine way to sock away some cash for the future. The S&P 500 from the end of 2003 to the projected earnings at the end of 2023, show a 7.12% increase per year. In addition, it paid an average of 1.92% per share per year in dividends, which if reinvested would have given you an additional 1.92% yield per year. Summing those two numbers, the S&P 500 over the course of 20 years has yielded 9% per year.

Measuring Performance of the S&P 500

Another way to measure the S&P 500’s return is by looking at a simple ratio, called a P/E ratio or price to earnings ratio. P/E is the price of the stock divided by the trailing 12 months earnings. The lower the value, the better the bargain. There are two ways to measure it – one is with operating earnings, and another is “as reported earnings.” As reported earnings are equivalent to the net income reported on income statements filed with the SEC. Operating earnings tend to be more stable since they don’t include non-operating line items like extraneous investments, interest and taxes. The average P/E for the S&P 500 over the previous 75 reported quarters of operating earnings is 18.58 and 24.91 for “as reported earnings”. However, if we normalize the “as reported earnings” in late 2008 and through 2009 where the P/E figures got highly skewed, the figure is about 21.

The estimated P/E for operating earnings in the 4^th quarter of 2022 with only 7% of the companies reporting is 20 (based on a buy price of $4000 per share for the S&P 500), and 22.18 based on as reported earnings. Both figures are close to their 20-year historical averages. It may be difficult for our human analog minds to fully comprehend a P/E of 20 but if we convert that to percentage terms, it comes to 5%. The cost of the S&P 500 is 22 times net income. If we invest $400 to buy 1 share in SPY (NYSE:SPY), we should expect about $18.18 in net income or about 4.5%.

Why buy stocks when bonds look attractive?

Why would you pay 22 times net income when some BA1/BB+ 1-3 year notes are yielding 6%+? It’s the growth on equity that allows the multiples to get compressed. The growth on the estimated earnings in Q4 2022 ($47.16 per theoretical share) over 5 years at the historical average growth rate of 7.12% per year, gets us to $66.76 per quarter. Take $66.76 multiply by 4 quarters and then multiply by a P/E of 21, gets us to an S&P 500 of 5,608 by the end of Q4 2027. That plus the dividend adds up to a 9% annual return assuming the growth over the past 20 years continues and the P/E ratio doesn’t swoon, which it does from time to time.

A couple of quick conclusions can be drawn from this. If you have a long-term horizon spanning many years and you want to simplify your investment strategy to a single investment class, invest in stocks. The yield is higher than bonds. If you don’t have the time, energy or inclination to invest in individual stocks, then pick a well-managed ETF like SPY (NYSE: SPY), pay an exceptional low 0.1% (1/10^th of 1%) management fee. Set it and forget it.

Over a 40-year working career, a 9% annual return coupled with a 10% savings rate in tax-deferred accounts (401K, IRA, etc.) will allow you to replace your income even with inflation running at 2.5% per year on average. Here is an example of a worker making $50,000 per year and saving $5000 per year (pretax). The chart shows an inflation adjusted rate of return of 6.5% (our 9% minus the average inflation rate of 2.5% per year). We aren’t increasing the investment amount by inflation because we want the final number in today’s dollars, so the $5000 invested per year stays flat.

After 40 years, the net worth of this individual will have grown to $935K in today’s dollars. Assuming you withdraw only 6% from the account thereafter, the account draw will be $56,114 in year 41. The remaining 3% retained covers inflation plus a bit of growth allowing this worker to preserve their principal year after year. In truth, an account like this will be volatile, and the growth will come in fits and starts; some years outperforming and other lagging, but again, if you have 4 decades to invest, this is the conventional way to do it.

Efficient Use of Capital

As a side note, every percentage counts. Businesses talk about implementing efficiencies, and they grow their income by increasing their output and reducing their overhead and cost of capital. Sometimes these gains are done 1% at a time, but they add up. You should follow the same approach and look for efficiencies wherever you can find them. If you leave a job, move that 401K over to an IRA – the 401K has extra overhead charges of 1% – sometimes more – and the investment choices are less flexible. These overhead charges are in addition to the standard mutual fund and ETF management fees. If you are invested in a mutual fund that isn’t beating the S&P 500 (very common) – roll it over to an ETF like SPY where the overhead is lower. Gaining an extra 1% on your return can really add up.

I think it is incredibly important to review these broad-based numbers occasionally just to understand the principles. If the broad blue-chip market is yielding 9% per year on average, and you have the time, energy and inclination to research individual stocks, you want to find stocks or sectors whose earnings are growing faster than 7% with dividend yields of 2% or higher or some other combination yielding higher returns.

US Employment Numbers

With all the gloomy news regarding the US economy, I just want to emphasis – nobody has a crystal ball. We simply can’t know with perfect clarity what’s to come. After the 2008/2009 swoon, I spent years studying how to predict the next recession, learning about this leading indicator and that one, modeling P/E values, GDP, inverted yield curves and other components that might make good predictors. I even built my own indicators, and you know what? They were next to useless and even worse, on the occasions where I acted on those predictors, simply destructive, in terms of missing out on potential gains by not being in the market. In fact, the most predictive indicator, if you can call it that, was the US unemployment rate which is published the first Friday of each month for the previous month, and then it gets adjusted over the next 2 months and if you follow the data year after year, you’ll notice that it continues to get adjusted although more modestly over time.

The most accurate unemployment data is based on the “Establishment Data” which is a survey of businesses, and the data is buried in Table B-1 of a lengthy report that the US Bureau of Labor Statistics publishes monthly. Look at the left side of the chart, “Not Seasonally adjusted” and just do a basic year-over-year comparison to remove the effects of seasonality. If this YoY number expressed as a percentage starts to deteriorate month after month (goes negative by a significant amount over a series of months), the probability of a recession is high. What does the data show in the most recent report?

The data shows 155 million non-farm folks employed in December 2022 vs. 150 million in December 2021 – that’s a 3.3% increase. That growth rate is comparable to some of the most bullish years in the 90s. That’s 5 million more people buying and spending money driving our economy. Not only are the numbers not deteriorating, they are growing. This healthy growth rate is incompatible with a recession – it is synonymous with a growing economy and a strong one. That’s it.

Could it deteriorate from here? Of course, but wake me up in 3 months and we’ll review the data again. The reasoning behind the importance of the employment numbers goes like this: 70% of GDP is driven by consumer spending. Strong consumer spending drives business spending. US consumers are remarkably predictable. If we are employed and getting raises, we receive money. If we have money, we spend it. The rule is simple, no deterioration in the employment numbers, no recession.

Broad Takeaways

There are a couple of take-aways that are extremely valuable:

(1) It is exceptionally difficult to time the entire market as a whole, so don’t try. By the time you realize the market has gone south using past data, the market will have corrected well beyond your means to get out of the market. Conversely, if you miss out on a substantial gain in the market, you’ll have to pile in at higher prices. Nothing is more painful than paying higher prices for investments. If you have the itch to time the broader market, set aside some percentage of cash to play the market. Better is to focus on timing individual sectors or stocks rather than trying to time the entire market.

(2) Don’t listen to the pundits. They have their own agendas and are next to useless for investment decisions. At best, consider them entertainers. There are some reliable folks to follow and if you find them, don’t blindly follow them. Try to understand their decisions by looking at the data and their sources. Try to validate their conclusions and track their returns back several years using publicly available data. I’ve looked at the funds of some of these so-called gurus and was astonished by how arrogantly some of these experts blew through investor wealth or made dubious investment decisions.

(3) Although past data is exceptionally slow, it is extremely valuable for predicting the future trajectory of individual stocks. Past data is the only reliable data we have.

(4) This fourth point is something I can’t emphasize enough and builds on point # 2. Do your own research and come to your own conclusions. You must know in your bones that you are right, and the only way to get that Michael Burry level of conviction is to roll up your sleeves and dig into the data. Data and math (and a ton of research) should be your only guiding light. Math is an exceptionally good BS detector. Math busted Bernie Madoff many years ahead of his imploding Ponzi scheme – why the SEC chose to ignore the math is beyond comprehension.

Sector Performance

If you can’t predict the market as a whole, can you predict inflection points in sectors? Based on the market’s crystal ball, here’s a 5-year trajectory for each major sector in the S&P 500.

The first column of numbers are the P/E ratios of each of the sectors in 2022. The next column to the right is the projected annual growth rate over the next 5 years. The PEG ratio is a ratio of that growth rate relative to P/E – the lower the value, the better the bargain. A PEG ratio is the P/E divided by the growth rate – note 11.46% is expressed as 11.46 and not 0.1146. The PEG ratio is a great reminder to find stocks that are not only selling cheaply relative to their earnings but find stocks that are growing fast. For those folks like me who find PEG ratios misleading, I’ve converted all of this to 5 year annual earnings return rates for each sector based on the current P/E yield and the projected growth rate, and added that into the 4^th column. These percentages are easier to digest and provide a better view of these types of projections.

Starting with the Index itself, you can see the annual earnings growth rate for the next 5 years is 7.28% per year – essentially identical to the average 20-year growth rate of 7.12%. You can also see some sectors outperforming and other underperforming. The hands down winner is the Energy sector (the worst sector – Real Estate, which makes up a very small percentage of the S&P 500 – down to a paltry 4.2% growth rate). Beginning in February 2021, I wrote 22 articles on the energy sector, adding my voice to a chorus of writers on Seeking Alpha, essentially pounding the table on the beaten down sector. Some of that time was spent debunking the extreme renewable energy myths pundits were peddling at that time, and warning investors not to invest in the hydrogen hype. The energy sector for oil and gas and the midstream companies that service them have done exceptionally well. Even with the run-up in equity prices for this sector, you can see the sector is still exceptionally undervalued relative to its earnings and projected growth rate.

I do believe we are in a multi-year bull market for oil and gas. Because the sector was so beaten down, buy-backs are having a tremendous compounding effect on the growth rate of these stocks. Consolidation has boosted the returns for individual names and discipline in the US shale sector has also prevented the type of commodity busts we saw in 2015/2016 and again in 2020. On the other hand, the sector is highly volatile and candidly speaking, nobody has a crystal ball. The stellar P/E of 8.04 was driven by a 2022 peak of $120/barrel WTI, natural gas prices that zoomed to $9/MMbtu (Henry Hub), and natural gas liquid values that were equally fantastic. WTI is currently sitting at $80/barrel and natural gas deflated to $3.42/MMbtu. Ethane prices are back in the cellar. I think these hefty S&P 500 projections for the energy sector will normalize somewhat. The time to pile into energy stocks and reap life changing gains was unquestionable 2020 and 2021 after the Covid energy bust, maybe 2022. Now, we’re just riding that wave to shore. It might be a bit late to join the party, but it’s still a great value.

Conclusion

Outside of the energy sector, stocks pulled back sharply in 2022. Frankly, they needed to after the frantic run up in valuations. We were getting too frothy with valuation stretched to breaking, but that doesn’t equate to a full-blown meltdown like we saw in 2000 and again in 2008. Analysts get paid to pontificate. We will continue to read dire forecasts of recession, but currently, the data doesn’t support the call. Despite the aggressive move by the Fed to raise interest rates, the employment numbers haven’t deteriorated – at least not yet. If the numbers falter later in the year for whatever reason and the market takes a tumble, you should welcome the additional buying power a market drop brings and buy more. Volatility breeds opportunity. In the meantime, stay fully invested in this market. Sure, earnings as measured by S&P 500 took a breather starting in Q1 of 2022, but earnings appear to be on the mend. Good luck to all!