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- Disposable income of the middle class is the balance from wages after spending on basic necessities like Food, Fuel and Housing.
- A change in disposable income impacts stock prices.
- Author published a machine learning formula based on disposable income to predict stock market and is using it to predict for 2020.
First, Time to Boast:
If you Google ‘S&P 500 to cross 3100 in 2019’, you will come across my Feb 2019 SeekingAlpha article last year as ranked 1st and displayed as a featured snippet. No other Wall Street analyst was close to accurately predicting the market that early in the year.
With this, I have been accurately predicting the stock market for more than 10 years, based on the factors that impact the disposable income of average middle-class people.
A major stock index like an S&P500 or Dow reflect the spending ability of an average middle-class person in America as 70% of the economy is based on consumer spending. If you look at the components of a major index like S&P 500, these are composed of companies that depend on disposable spending by middle class, after spending on basic necessities like Food, Fuel and Housing. This spending is also helped by declining interest rates and vice-versa.
I published the Sharma Disposable Income formula in a 2014 SeekingAlpha article which I created using machine learning on macro economic factors that matter to average middle class consumers in America (Is There A Formula To Predict The Dow, S&P For 2014?).
Now, Is S&P500 PE ratio too high ?
On 24th Jan 2020, the PE Ratio of S&P 500 is 24.8 which is 80% higher than the historical average of 15 and the highest after 2009 when economy started recovering after the great recession.
(above chart is from S&P 500 PE Ratio,
Below chart is from YCharts)
This high PE ratio may sound alarming but let us look at the estimates of forward PE ratio next year. The forward PE ratio of S&P500 is 19 at the current prices which shows it is still what has been for the last many years.
Why such a high PE is reasonable?
Historically, we have seen the PE ratio of S&P500 around 15 and the ten year treasury yield around 5%. Looking at it from an investor’s point, an investor putting $100 in a ten year treasury gets an earning of $5 which comes to a PE ratio of 20. On the other hand, a corporate investor gets a PE ratio of 15. A corporate investor pays a lower price for the same earnings as he is risking his investment. Now this discount between 20 and 15 is 25%.
Now with a ten year treasury yield of around 1.6 now, the PE ratio for it is 60. If an investor is willing to risk the safety of a ten year treasury and invests in a corporation, he should expect at least 25% discount on the price, which comes to a PE ratio of 45.
However, the PE ratio of S&P500 is only 24 now and the forward PE is 19, so the PE ratio is reasonable, provided the ten year yield does not go up. As per multiple assurances of the Fed Chair Jerome Powell and pressure from President Trump, the yield should not go up this year, at least till the election in November. I will discuss this in a later section here.
Also, Is the US household debt bubble about to be burst ?
The US household income has reached historically high figure of $14.15 trillion. But is this a bubble about to be burst? To examine this question, let us compare it with the median household incomes.
The chart below (from Reuters.com) shows historical US household debt:
(Data below is from : Historical Income Tables: Households)
The average middle class household income in US is $86K in 2018 and by the end of 2020, I expect it to cross $90K. It was $80K in 2016 as per the chart above.
This data shows that incomes are growing at higher rate than household debt. So, as long as we continue to have low interest rates, the chances of bubble getting burst are low.
In real terms, we should remember that non – supervisory job incomes are still below their 1970 levels and wages need to grow much higher to match the good old days.
Previous Stock Market Predictions based on Sharma Disposable Income Formula/Methodology:
|Year||My Market Prediction||Actual Market Movement||My Dow/S&P % Prediction||Actual Dow and S&P % Movement||Link|
|2009||Up||Up||Higher, no number given||Higher, 15 and 21||U.S. Economy Looks Ready to Bounce|
|2010||Up||Up||Higher, between 13 and 23%||Higher, 10 and 13||Where Will the Dow Be at the End of 2010?|
|2011||Down||Down||Lower, no number given||Higher and Lower, 5 and -1||Why I See the Dow and Disposable Income Going Lower in 2011|
|2012||Up||Up||Higher, 10%||Higher, 5 and 13||Dow Will Be Closer To 14000 By The End Of 2012|
|2013||– (no article written)||– (no article written)|
|2014||Up||Up||Higher, 20%||Higher, 8 and 12||Is There A Formula To Predict The Dow, S&P For 2014?|
|2015||Down or Up||Down||Either, Between -3 and 11%||Lower, (-2) and (-1)||Where Will The Dow, S&P Be At The End Of 2015|
|2016||– (no article written)||– (no article written)|
|2017||Up||Up||Higher, by 15%||Higher, 24 and 18||Where Will The Dow Be By The End Of|
|2018||Up or Down||Down||+1 or -1%||Lower,-7 and -4||Where Will The Dow And S&P Be By The End Of This Year (2018)?|
|2019||Up||Up||Higher by 20%||Higher, 27 and 12||S&P 500 Should Cross 3100 In 2019, Per Disposable Income Formula|
Finally, how high will the S&P 500 go this year ?
For this, I rely on my time-tested Sharma disposable income formula. This formula was created based on machine learning and has an R square of 0.4 which is an unusually high number in economics.
2020 being an election year, an incumbent President Trump will leave no stops to help the Stock Market. Here are my estimates for 2020:
Wages growth minus CPI growth:
With the China trade war in backburner now, I expect the Wages to grow slightly higher than CPI. I estimate the wages to grow between 1% and 2 % higher than CPI.
There is a low chance of a war in Middle East, after the recent Iran episode, Gas Prices have already declined and will continue to fall. I would estimate these to be falling by at least 15% this year. (chart below from gasbuddy.com)
With low interest rates, Home Prices will grow this year slightly. I would give it a 3 to 5% increase for my formula. Increased home prices have negative impact on people’s pockets.
Presidential Election and Interest Rates:
First, who will win the Presidential election this year ? On the day of last Presidential election 8th Nov 2016, I gave a Radio Interview on the Ed Tyll show where I explained with the disposable income formula why President Trump would win, despite all the polls suggesting otherwise.
(You can listen to that Radio Interview at Formula To Win by By Donald Trump )
Americans vote based on the promises for future and give less weightage to what has already been accomplished. If the China Trade Deal is completed way too early before the elections, voters will weigh the remaining agenda items of President Trump and compare those with the list of promises being made by the Democrat Candidates. I think the final China Trade deal will be done closer to the elections or not completed during this term of the President and that will help President Trump.
Due to the pressure on FED by President Trump to take US interest rates at par with Europe, the Fed would not increase interest rates till the elections. However, if the Democrat Party’s Candidates urge the Fed to raise interest rates, the Fed may slightly increase interest rates closer to the elections. Due to strong economy, the changes of lowering interest rates further are low.
In Scenario 1, I would consider no change for my calculations on the 10 year treasury yield. In Scenario2, I would consider an increase of only 0.5 percentage in the 10 year treasury yield, due to strong economy.
|Home Price inc||-0.8||5||-4|
|Home Price * 10 year treasury||-1.4||0||0|
|Ten year treasury||-7.4||0||0|
|Home Price inc||-0.8||5||-4|
|Home Price * 10 year treasury||-1.4||2.5||-3.5|
|Ten year treasury||-7.4||0.5||-3.7|
Applying these calculated percentage changes to S&P500 numbers on 1st Jan 2020, by the end of December 31, 2020, Scenario 1 says the S&P 500 should cross 3800 and Scenario 2 says it would cross 4100. Using the average, I would says it would be around 4000.
Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
This article originally published at SeekingAlpha.com