The S&P 500 stock market average index has had a remarkable history of tracking the recovery in the return on equity (ROE) above the cost of equity (COE) for its average of 500 component companies. Each time ROE has risen above COE, a bull market occurred as the spread between ROE and COE widened toward 10%, as in the late 1990’s, years 2002 to 2007, and the latest recovery from 2009 to 2016.

1. ROE Less COE Spread Drives
Performance of S&P 500
The S&P 500 stock market average index has had a remarkable
history of tracking the recovery in the return on equity (ROE) above
the cost of equity (COE) for its average of 500 component
companies (see Chart I). Each time ROE has risen above COE, a
bull market occurred as the spread between ROE and COE
widened toward 10%, as in the late 1990’s, years 2002 to 2007,
and the latest recovery from 2009 to 2016. To better understand
the consistent performance to ROE less COE, IDC Financial
Publishing, Inc. (IDCFP) examines the components.

2. Chart I

3. Return on equity (ROE) in Chart II demonstrates the profitability of
America’s industry and companies. In the early 1990’s, ROE
accelerated above the 10% COE in 1994 to profit highs of 18% at
year-end 1999. Again in 2002, ROE rose above COE and
accelerated to peak levels of 17.3% at the end of 2006. In the latest
recovery, beginning in 2009 with ROE rising above COE, ROE
accelerated to a peak of 14.8% in late 2011 and retested that level
at year-end 2014, which set the stage for the latest bull market. Tax
cuts, deregulation, and other economic stimuli under the Trump
administration are forecast to increase the ROE for the S&P 500 to
16% in 2018.
IDC Financial Publishing, Inc. normally only focuses on bank
stock valuations, ROE, COE and price to book value. Given
our unique “Cost of Equity” (COE), IDCFP tested the concept
against the S&P 500.

4. Chart II

5. Beneath the cycle recoveries in ROE, however, was a secular decline
in COE from the 12% level in 1990 to under 5% today. Despite the
moderately lower peaks in ROE and the recent slowdown to under
12%, the consistent decline in COE drove the spread between ROE
and COE and the last three bull markets (see Charts I and II). The
COE as defined by IDCFP is the 30-year T-Bond yield plus one-half
of this yield to account for an equity premium plus 20% of the
standard deviation of the ROE, accounting for specific risk in the S&P
average.
The recovery in the spread of ROE less COE to around 10% in 1995
to 1999, 2004 to 2006, and 2011 to 2016 provided peak valuations for
the S&P 500 of around 3 times book value per share (see Chart III).
In the bull market in the late 1990’s, price to book rose to 3 times in
1996, but then the tech boom took hold with valuation temporarily
rising to 5 times book in 1999.

6. The price floor for corrections in the S&P 500 were normally 2.5
times book value per share. However, major declines in ROE, as
occurred in 2008 and 2009, drove valuation of the S&P 500 to
slightly below 2 times book value.
A rise in 30-year T-Bond yields to 3.5% to 4.0% and an increase in
COE to 5.5% to 6.0% in 2017-18 requires an ROE of 16.0% in order
to maintain an ROE-COE spread of 10% and provide forecast price
to book multiples of 3.0 times. Book value as of December 31,
2016, is estimated at 768. A continued economic recovery under
the Trump administration forecasts book value to rise to 852 in 2017
and with a full year of corporate tax cuts and other economic stimuli
in 2018 to, as high as 945 or even 1,000. Upside full-value
forecasts at 3 times book value for 2017 are 2,556 and for 2018
levels of 2,835 to 3,000 (see Chart III).

7. Chart III

8. With the upside in pricing of the S&P 500 above 3 times book and
a major downside move to 2 times book, the future levels of ROE
and economic activity are critical. The best leading indicator of
S&P 500 ROE is the Housing Market Index (HMI). The HMI is a
survey of realtors’ expectations of home sales, traffic and other
housing indicators. The HMI peaked in mid-2005, leading the peak
and decline in S&P 500 ROE in June 2007. The low in HMI in
March, 2009 predicted the low in ROE as of March, 2009.
Currently, HMI reached new cycle highs, predicting rising ROEs for
the S&P 500 (see Chart IV).

9. Chart IV

10. HMI was successful in predicting the cycle in ROE for the S&P 500,
and is also useful in predicting the cycle highs in the price of the S&P
500 (see Chart V).
Chart V