Why Now's The Time To Make Money In The Stock Market – Forbes

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You hear all the time that the long-running bull market must run out of energy soon. But Nicholas Atkeson and Andrew Houghton, the founding principals of Delta Investment Management, show with simple math why the market still has plenty of opportunity to make money:

There is a time to reap and a time to sow. Investing is a thoughtful activity. If you don’t have an investment thesis that is the output of a sound investing process, then don’t invest. It’s that simple. During times when your disciplined investment process shows positive expected returns, invest (sow).

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What is our current investment thesis?  Now is a time to make money:

  1. Earnings are expected to be up roughly 22% year-over-year in 2017. The first quarter earnings season positively reinforced this expectation.

  2. There are no significant signs of recession in the next six months.
  3. International economies are expanding – clearly good for international stocks and global growth benefits U.S. stocks, especially large capitalization stocks with international exposure.
  4. Low bond returns continue to make stocks relatively attractive – the Fed Model.

The Fed Model

The Fed Model is an informal model that came into being in a Federal Reserve report issued in 1997. The model compares the stock market’s earnings yield (earnings/price, or E/P) to the yield on 10-year Treasury bonds. The Fed Model states that bond and stock market are in equilibrium, fairly valued, when the one-year forward-looking earnings yield equals the 10-year Treasury yield.

The Fed Model is a simple tool to measure attractiveness of stocks. The 10-year Treasury yield is roughly 2.2%. The earnings yield of the S&P 500 is 5.4% (2017 estimated operating earnings estimate is $131.77 divided by S&P 500 index 2,430 equals 5.4%). According to the Fed Model, stocks are attractive.

The Fed Model shows stocks and bonds are fairly valued by comparing their yields.

Delta Investment Management

The Fed Model shows stocks and bonds are fairly valued by comparing their yields.

If we modify the Fed Model by replacing 10-year Treasury yield with the corporate Baa (lower medium grade) bond yield, stocks continue to be attractive on a relative yield basis. Since the beginning of the year, interest rates have notched lower and earnings have been revised higher making stocks even more attractive.

This is the Fed Model adjusted to sub in corporate bonds. The result is the same.

Delta Investment Management

This is the Fed Model adjusted to sub in corporate bonds. The result is the same.

Why would we modify the Fed Model to use corporate bonds rather than government bonds? The main reason is to match the risk level of the bonds with stocks.  U.S. government bonds are considered to have very low default risk as the U.S. Treasury can print money to repay the bonds. Corporations can’t print money. Corporations can’t absolutely guarantee bond repayment or future earnings projections. By using Baa rated corporate bonds, we believe we have matched the bond default risk to the earnings risk of the S&P 500.

During a May 8 interview with CNBC, Warren Buffett talked about the importance of interest rates when considering stock valuation. Buffett stated that the valuation of stocks is driven in part by interest rates because the value of companies is based on the discounted value of their cash flows. “Stocks are dirt cheap,” Buffett said, if rates stay around current levels or increase only modestly over the next 10-plus years.