S&P 500 EARNINGS, VALUATION, AND THE PANDEMIC: Introduction

The following is the Introduction to our latest study in our "Predicting the Markets" series. The paperback and e-book are available on Amazon here. The other studies in this series are available on my Amazon author's page here.

I started my career on Wall Street in 1978. I spent the prior year at the Federal Reserve Bank of New York in the economics research department after receiving my undergraduate degree in economics and government from Cornell University in 1972 and my PhD in economics from Yale University in 1976. Over the past 40-plus years, I’ve worked as both the chief economist and the chief investment strategist at several firms on Wall Street. Since January 2007, I’ve been the president of my own consulting firm, Yardeni Research, Inc.

My job continues to be to predict the financial markets, particularly the major stock, bond, commodity, and foreign exchange markets around the world. I’ve learned a lot about these markets over the years. I recently started sharing what I’ve learned in a series of books and studies.

In this study, I will focus on the S&P 500 stock price index, examining how it is determined by the earnings of the 500 companies that are included in the index and the valuation of those earnings by the stock market.

Why pick the S&P 500?

The S&P 500 is a stock market index that measures the stock price performance of 500 large companies listed on stock exchanges in the United States. It is one of the most widely followed equity indexes. The stocks in this index are a representative sample of leading companies in leading industries. Many equity managers benchmark the performance of their portfolios to the S&P 500. Among the largest exchange-traded funds are those that track the S&P 500. The S&P 500 represents more than 83% of the total domestic US equity market capitalization.[1]

The widely followed Dow Jones Industrials Average (DJIA) has only 30 companies. It was launched in 1896 and was a spin-off of the Dow Jones Transportation Average, which was first compiled in 1884 by Charles Dow, the co-founder of Dow Jones & Company. The S&P 500 dates back to 1923. That year, the Standard Statistics Company (founded in 1906 as the “Standard Statistics Bureau”) developed its first stock market index, consisting of the stocks of 233 US companies and 26 industries, computed weekly. (The company also began rating mortgage bonds in 1923.) In 1926, it developed a 90-stock index, computed daily. In 1941, Poor’s Publishing merged with Standard Statistics Company to form Standard & Poor’s (S&P). On March 4, 1957, the index was expanded to its current 500 companies and was renamed the “S&P 500 Stock Composite Index.”

The components of the S&P 500 index and other S&P indexes are selected by the firm’s US Index Committee, which meets monthly. All committee members are full-time professional members of the firm’s Indices staff. At each meeting, committee members review pending corporate actions that may affect the indexes’ constituent companies, statistics comparing the indexes’ composition to the broad stock market, candidate companies under consideration for addition to an index, and the bearing of any significant market events on the indexes.

The committee identifies important industries within the US equity market, approximates the relative weight of these industries in terms of market capitalization, and then allocates a representative sample of stocks within each industry of the S&P 500. There are 11 sectors according to the Global Industry Classification Standard (GICS): Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate, and Utilities.[2] These sectors are further divided into 24 industry groups, 69 industries, and 158 subindustries.

Candidates for inclusion in the S&P 500 index must meet specific criteria in eight areas: market capitalization, liquidity, domicile, public float, GICS, financial viability, length of time publicly traded, and stock exchange listing. The index is reconstituted quarterly, though changes are made infrequently.

The S&P 500 index is a free-float, capitalization-weighted index. That means that companies are weighted in the index in proportion to their market capitalizations. To determine the market-capitalization weight of a company, only the number of shares available for public trading (free float) is used. Shares held by insiders or by controlling shareholders that are not publicly traded are excluded from the calculation. The largest companies (based on market capitalization) in the S&P 500 account for a substantial portion of its total market capitalization. Since the index is market-capitalization weighted, these companies have the greatest influence on the index’s price performance.

Notwithstanding occasional bear markets, the S&P 500 has been a great investment over the years—so much so that “S&P” could stand for “Success & Profit.” Since January 1, 1955, through September 2, 2020, the index has been down in bear markets during 3,029 of the 16,535 trading days—i.e., just 18.3% of the time. It has risen at a compounded annual rate of 6%, a rate that doubles the value of this portfolio every 12 years. And that doesn’t include the dividend return provided by many of the S&P 500 companies.

The first chapter in our study covers the various measures of earnings for the S&P 500 and why we favor forward earnings among them. The second chapter discusses various models of valuation, again focusing on the S&P 500. The final chapter uses the resulting analytical framework to review how it has worked in good times and bad, focusing on the Great Financial Crisis and the Great Virus Crisis.

[1] See S&P Global, S&P 500: The Gauge of the Market Economy and S&P U.S. Indices Methodology, August 2020. See S&P Dow Jones Indices.

[2] The Global Industry Classification Standard is jointly developed and maintained by S&P Dow Jones Indices and MSCI.

INCOME & WEALTH IN AMERICA: Who Owns Equities?

A large team of the Fed’s researchers have been busy constructing a new database containing quarterly estimates of the distribution of US household wealth since 1989. They launched it with the release of a March 2019 working paper titled “Introducing the Distributional Financial Accounts of the United States.” The Distributional Financial Accounts (DFA) is an impressive accomplishment combining quarterly aggregate measures of household wealth from the Financial Accounts of the United States (FA) and triennial wealth distribution measures from the Survey of Consumer Finances (SCF).

I. A much more comprehensive database. We believe that the new database can be used to resolve lots of controversial issues about wealth distribution in the US. The DFA’s balance sheet of the household sector is much more comprehensive and timely than previously existing sources. The Fed’s researchers observe that their “approach produces rich and reliable measures of the distribution of the Financial Accounts’ household-sector assets and liabilities for each quarter from 1989 to the present.” The data can be used to study the distribution of wealth in America by wealth and income percentiles, education, age, generation, and race. Melissa and I intend to do just that in coming months with the goal of assembling a comprehensive study tentatively titled “Income & Wealth in America: Myths & Realities.”

II. Who owns equities in America, according to FA? Aggregate data are available in Table L.223 in the FA for corporate equities held by each of the major sectors in the accounts. Unlike the DFA, the household sector in the FA includes nonprofit organizations, and this sector’s data are calculated residually from the other accounts. Let’s review our findings:

(1) The supply side of equities. The total market value of equities held in the US during Q2-2020 was $52.0 trillion, with domestic issues totaling $43.5 trillion and foreign issues totaling $8.5 trillion (Fig. 1). Domestic issues included $33.5 trillion of nonfinancial issues and $10.0 trillion of financial issues and consisted of $37.2 trillion of publicly traded and $6.3 trillion of closely held equities (Fig. 2 and Fig. 3). The $6.3 trillion of closely held equity consisted of $4.7 trillion in S corporations and $1.6 trillion in C corporations (Fig. 4).

(2) Ownership by sectors. During Q2-2020, of the $52.0 trillion in equities, the major sectors directly held the following amounts and percentage shares: household sector ($19.5 trillion, 37.6%), mutual funds and exchange-traded funds (ETFs) ($14.5 trillion, 27.8%), rest of the world ($8.2 trillion, 15.8%), and institutional investors ($7.0 trillion, 13.4%) (Fig. 5 and Fig. 6).

(3) Directly and indirectly held by households. The FA includes a Table B.101e titled “Balance Sheet of Households and Nonprofit Organizations with Debt and Equity Holdings Detail.” It provides extraordinary insight into the indirect equity holdings of households through life insurance companies, private and public pension funds, and mutual funds. During Q2-2020, households and nonprofits directly held $19.5 trillion (37.6% of all equities) and indirectly held $12.4 trillion (23.8% of the total) (Fig. 7). In other words, their direct and indirect holdings of equities totaled $31.9 trillion, or 61.4% of all equities (Fig. 8). Interestingly, this percentage has been remarkably stable around 65% since the early 1980s.

III. Which households own equities, according to DFA? The link between the household sector in the FA and in the DFA is Table B.101.h titled “Balance Sheet of Households,” which unlike Table L.223 excludes nonprofit organizations from the household sector. On the other hand, this balance sheet shows the household sector’s combined holdings of corporate equities and mutual fund shares, which include bond funds but not money market mutual funds or ETFs. The assets and liabilities in this version of the household balance sheet are the ones for which the DFA provides all the data needed for analyzing the distribution of household net worth. (See “Household Balance Sheet” from our forthcoming study on income and wealth in America.)

Now, let’s analyze the distribution of the DFA’s various series for corporate equites and mutual fund shares held by households, sliced and diced by wealth percentile, generation, and education:

(1) DFA by wealth percentiles. We repeat: The DFA is based on the FA’s Table B.101.h, which is the “Balance Sheet of Households” excluding the assets and liabilities of nonprofit organizations. It shows only annual data and reveals that corporate equities and mutual funds held by households at the end of 2019 totaled $29.1 trillion (Fig. 9). In the DFA, this series is shown on a quarterly basis. By the way, we can derive a similar quarterly series as the sum of corporate equities held by households and nonprofits plus mutual fund shares held by them, as reported in FA Table L.224, which excludes money market funds and ETFs (Fig. 10).

The DFA shows that corporate equities and mutual fund shares held by households was down slightly to $26.8 trillion during Q2-2020, with the following ownership and percentage shares of the total among wealth percentile groups: top 1% ($14.1 trillion, 52.4%), 90%-99% ($9.5 trillion, 35.8%), 50%-90% ($3.0 trillion, 11.2%), and bottom 50% ($0.2 trillion, 0.6%) (Fig. 11 and Fig. 12).

The bottom 50% never owned more than 1.6% of this asset category. The 50%-90% crowd’s share peaked at 21.4% during Q3-2002 and since has fallen to 11.2% currently. The 90%-99% group has held a fairly steady share around 35% since the early 1990s. The top 1% has ranged between a low of 40.2% and a high of 52.8%.

The widespread notion that the very rich own a disproportionate share of corporate equities is true, but their collective share is more like 50% of the total held by households than the urban legend of 80%-90%.

(2) DFA by generations. The DFA allows us to compare the amount of an asset or liability held and the percentage shares by four generations: Silent (born before 1946), Baby Boomer (1946-1964), GenX (1965-1980), and Millennial (1981-96).

Here are the values of corporate equities and mutual funds held by the four generations and their percentage shares during Q2-2020: Silent ($5.1 trillion, 19.0%), Baby Boomer ($14.8 trillion, 55.3%), GenX ($6.3 trillion, 23.4%), and Millennial ($0.6 trillion, 2.2%) (Fig. 13 and Fig. 14).

Since the start of the data in 1989, the percentage share held by the Silent generation has dropped from around 80%-90% to 19% currently, while the percentage share of the Baby Boom generation increased from 10%-20% to 55% currently. The GenX share was close to zero in early 2009 and has been trending up; it’s around 23% currently. The Millennials’ share remains close to zero.

(3) DFA by education. Finally for now, let’s have a look at the impact of education on the ownership of corporate equities and mutual fund shares. The DFA data show that households headed by college-educated persons held 82.9% of corporate equities and mutual fund shares during Q2-2020 (Fig. 15 and Fig. 16). That percentage has been trending higher since Q1-1995, when it fell to a series low of 60.2%. Households with heads who had some college, high school, and no high school owned only 9.9%, 6.3%, and 0.8%. Education is clearly a vitally important determinant of financial well-being.

IV. What's the bottom line? Since the early 1960s, the household sector (including nonprofit organizations) has directly and indirectly held 65% of equities in America. Of the equities held by households (excluding nonprofit organizations), the “1%” hold around 50% of this asset class. Older people with college educations tend to own more equities than younger ones with less education.

Gridlock Is More Bullish Than Blue or Red Waves

I’ve often observed that the US economy has performed remarkably well over the years despite Washington. Presidents like to take credit for the millions of jobs they have created or boast about the number of jobs they will create. Presidential candidates make similar promises about how their policies will boost employment by millions if they are elected or re-elected.

The reality is that it is businesses that create jobs, not politicians. Businesses tend to do a better job of creating jobs when they aren’t burdened by Washington’s meddling in their affairs. Since Washington almost always meddles to varying degrees with the economy, it’s amazing how so many businesses in so many industries continue to be profitable and to expand their capacity and payrolls, with only recessions briefly tripping them up.

This line of thinking leads to the widely held notion that the economy and the stock market do best when Washington’s politicians are stymied from meddling as much as they would like by political gridlock, i.e., when the party of the president doesn’t have majorities in the House and/or the Senate. Divided government is bullish, while unified government is bearish, or less bullish.

Our governing system of “checks and balances” is the core principle that guided the nation’s founders when they wrote the US Constitution. In addition, many of them signed the Declaration of Independence, which declared: “Governments are instituted among Men, deriving their just powers from the consent of the governed.” They were mostly lawyers, and they designed a system that worked best when it didn’t allow any majority party to have too much power for too long.

By the way, Abraham Lincoln, who was a lawyer as well as a president, famously restated the founding principle in his Gettysburg Address: “that these dead shall not have died in vain—that this nation, under God, shall have a new birth of freedom—and that government of the people, by the people, for the people, shall not perish from the Earth.”

Today, many investors fear that a Blue Wave on Election Day could happen, giving the Democrats’ unfettered power to implement their expansive and expensive agenda, including increasing federal spending, raising federal taxes, imposing more regulations, packing the Supreme Court, and so on. Wall Street strategists, including yours truly, countered that the bearish impact of higher taxes and more regulations should be offset by more spending in the Blue Wave scenario.

At my firm, we recently analyze the performance of the S&P 500 under unified and divided government since FDR took office (Fig. 1). We calculated the percentage increases in the index from January-through-December periods during the two alternative regimes. We found that during the previous six Blue Waves, the S&P 500 increased 56% on average. During the previous three Red Waves, the index rose 35% on average. During the seven periods of divided government, the S&P 500 rose 60% on average.

This suggests that gridlock is more bullish than the two unified alternatives, which are also bullish, but less so, with Blue Waves more bullish than Red Waves. Perhaps the market figures that government is less likely to grow much bigger when the government is divided rather than unified. In any event, the government has been getting bigger and more meddlesome for years, as evidenced by ever-widening federal budget deficits and mounting federal government debt (Fig. 2). (The founders generally disapproved of debt and believed that the amount the country owed should be limited.)

Alternatively, could it be that the White House and the Congress don’t matter as much to the stock market as does the Fed? I think so, and so does Barron’s, which chose to run a cover story on Fed Chair Jerome Powell with the title “This Is Jerome Powell’s Moment, No Matter Who Wins” this week. The article, written by Nick Jasinski, observed: “Tuesday’s election will be a critical one for the nation. But for those nervous about the economy, the Fed’s chairman may just be the most important man in Washington.”

I was quoted in the piece as follows: “He’s a pragmatic pivoter. He’s done what he set out to do, and [shown a willingness to] change his mind depending on what the situation demands, but not be totally inconsistent.” Chapter 8 of my book Fed Watching for Fun & Profit is titled “Jerome Powell: The Pragmatic Pivoter.”

I previously have observed that no matter who wins the White House on Tuesday (or before Inauguration Day), he won’t be as important as Powell, whose first term doesn’t end until early 2022. Powell has made it very clear that he intends to keep the yield curve close to zero. The federal funds rate was lowered to zero on March 15 (Fig. 3).

The 10-year US Treasury bond yield has been below 1.00% since March 20 (Fig. 4). From February through September, the Treasury issued $670 billion in notes and $259 billion in bonds (Fig. 5 and Fig. 6). Over the same period, the Fed purchased $1,223 billion in notes and $338 billion in bonds. Previously, I’ve argued that if the bond yield rises above 1.00%, the Fed will most likely announce an official target range below 1.00%, a.k.a. “yield-curve targeting.”

Finally, since Halloween coincided with a full moon this weekend, all the more reason to fear the front cover curse. What could possibly go wrong for Powell?