Monetary tightening history suggests S&P 500 correction

According to Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE)’s cross asset team, the S&P 500 (INDEXSP:.INX) is ripe for a correction as the Fed starts reducing money supply. In Japan, the Nikkei had a 20% correction when the Bank of Japan contracted its asset base from 2006 to 2007 and the index still needs to recover to pre-correction levels. Even in the United States, back when the Federal Reserve started tightening in early 1994, the S&P 500 experienced a 9% correction during the rest of that year. Index recovered by the first quarter of 1995. The third chart below shows that the S&P 500 (INDEXSP:.INX) also experienced corrections after quantitative easing (QE) 1 and 2 ended in 2010 and 2011, with the majority of the downturn occurring in less than 2 months.

Societe Generale

Source: Societe Generale Cross Asset Research/Asset Allocation

Source: Societe Generale Cross Asset Research/Asset Allocation

Source: Societe Generale Cross Asset Research/Asset Allocation

Equities could be affected by rising bond yields

As bond yields rise, equities look less attractive relative to bonds. The S&P 500 (INDEXSP:.INX) equity risk premium is at 4.7%, and according to Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE)’s analysis, a 50 bp increase in 10 year Treasury yields could bring the equity risk premium to 4.2%. Such level is close to equities being fairly priced relative to bonds. Additionally, the dividend yield on the S&P 500 is at 1.89% as of November 1, 2013, close to a low of 1.11% reached on August 2000 and below its long term mean of 4.43%. Meanwhile, the U.S. ten year Treasury is yielding 2.65% (as of November 1, 2013), above its record low of 1.53% reached on July 2012 but still low relative to its long term mean of 4.64%. Lower equity yields may make equities less attractive as part of an income producing strategy to supplement bond coupons. Also, dividends are growing at 16.27% (as of September 30, 2013), close to the high of 18.25% pace reached on December 2012 and well above the long term mean of 5.28%. The peaking of dividend growth together with low dividend yields may suggest that dividends are becoming a smaller component of stock total returns. Furthermore, if decreasing earnings growth materializes in 2013 and beyond, capital appreciation may also decline for stock producing lower total returns and decreasing equity attractiveness relative to bonds.

The correlation between 10 year U.S. Treasury returns and S&P 500 (INDEXSP:.INX) returns has turned positive for the first time in five years, which marks the beginning of the most recent financial crisis, hovering around 0.4. This could suggest an equity correction as ten year Treasury bond returns shrink due to rising rates.

Source: Societe Generale Cross Asset Research/Asset Allocation

Valuations are high relative to history and relative to other markets

The S&P 500 (INDEXSP:.INX) is currently trading at a Shiller PE of 24.77, about 50% above its long term mean Shiller PE of 16.49. Note from the chart below that corrections started close to the current level in the 1930s, 1960s, and 1970s. Shiller’s PE is also known as the cyclically adjusted PE ratio (CAPE), and it is calculated by dividing price over the last 10 years of inflation-adjusted earnings for index members. Earnings growth is also slowing relative to history. The most recent year on year annual earnings growth rate was 3.45%, well below the long term mean of 28.51% and the long term median of 12.41%. Slower earnings growth also suggest potential for earning reporting disappointments and lower earnings guidance in the current third quarter 2013 earnings season.

Shiller PE

S&P 500 earnings growth: Societe Generale

Source: Robert Shiller

Relative to other countries, the U.S. is trading at a premium on a price to book value basis and its potential return on equity. Only Switzerland is more expensive than the U.S. based on this metric. The chart suggests that the potential for higher returns in the U.S. is limited as the market has already priced in earnings gains. Furthermore, the U.S. market has outperformed other markets since October 2007, making it ripe for a correction. Earnings growth expectations for U.S. stocks continue to be high, around

10% for 2014 and 2015, according to Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) calculations. Given that earnings growth is decelerating, growing profits at low double digit rates becomes harder to achieve.

Source: Societe Generale Cross Asset Research/Asset Allocation

Revenue growth slower in fourth quarter 2013: Societe Generale

So far in the current third quarter earnings reporting season, revenue growth has been slow. So far revenues have grown 3.6%, 4.3% excluding financials in the S&P 500 index. Roughly 74% of the companies are reporting higher revenues year over year. However, only 39% had upside earnings surprises relative to consensus expectations. The pace of earnings disappointments has accelerated from the low to mid-teens in 2012 to 21% in second quarter of 2013 and 37% so far in the current reporting season. Such trend does not bode well for meeting earnings growth expectations for 2014 and 2015 that are around 10% per year.

Source: Societe Generale Cross Asset Research/Asset Allocation