Today we take a look at why gn ‘r is shaking the markets. No, it’s not a tribute to Axl and Slash, but we’ll do our best to incorporate “Welcome to the Jungle” into this financial market update.

Instead, we’re talking about a small “g” and a small “r” – two of the most important inputs for stock valuations. In fact, the little “g’s” and little “r’s” are so powerful that they might even justify current market valuations and provide a warning for the next few quarters.

But first, when it comes to market valuations, the price-to-earnings (PE) ratio is certainly the most common measure.

PE is a quick and easy to assess indicator, especially against historical levels. For example, the S&P 500 collectively trades at 21 times earnings. That’s high based on the long-term historical average of 16x, but that’s lazy math. Price divided by profits, whether it’s an estimate or an estimate for the next 12 months, barely sums up the value of a business or market. It ignores earnings growth and growth rates, the variability of those earnings, the leverage or returns available in competing investments, among others. We are not implying that investors should ignore PE ratios, but this is just an entry.

More serious valuation approaches are often built around the time value of money, a methodology widely used in the bond market. The names of these models include discounted cash flow or discounted dividend models. Essentially, they’re trying to value something in today’s dollars – a company, an index, a bond – based on cash flow, dividends, or earnings for many years to come, discounted to reflect time and risk. Although the formulas differ, the following is a loose generalization that will suffice us:

The “r” is influenced by the variability of the future growth rate of the investment. If you are unsure of “g” or the future, then “r” is greater. Yields or benchmarks, such as the risk-free rate or the yield on government bonds, influence “r”. Inflation has an impact on “r”. If inflation is higher than future income, it must be discounted at a higher rate. The “r” attempts to capture many of the risks and uncertainties associated with future earnings, dividends, or cash flows.

**“G” amount and “r” smaller: an excellent combo for markets**

If ‘g’ increases, the value of the investment increases. Logically, faster growing cash flow or earnings are clearly good. Over the past year and a half, that is precisely what has happened, helping the markets rise. It doesn’t take a professional tea leaf reader to see revenue skyrocketing, significantly exceeding expectations. Clearly, reopening the economy has been a huge tailwind for profits, as have fiscal and monetary stimulus to help it. Companies have also pivoted and have adapted very well, on the whole, to this constantly changing environment. The degree of this profit growth is mind-boggling. Assuming the forecast for third and fourth quarter earnings holds, 2021 will hit around $ 199 for the S&P 500. The previous peak in calendar earnings was $ 157 in 2019 and only broke the $ 100 level until after in 2013. This rapid profit growth pushed the long term ‘g’ higher.

The little “g” and the little “r” in the denominator of the equation have a huge impact on the value of the investment. The “g” is the expected long-term or perpetual annual growth rate of dividend, cash flow, or earnings from the upper numerator of the equation. Of course, who knows what the future holds? For a company you can probably have a reasonable idea of the profits for a year or two… but in 2030? Also, $ 1 in earnings or dividends in 2030 is certainly worth less than $ 1 in 2021. The “r” discounts these future earnings.

At the same time, ‘r’ has become smaller. The largest reduction in “r” is probably due to the decrease in uncertainty surrounding the impact of the pandemic. Less risk equals a lower “r”.

And if “r” is dragged down by a combination of less future uncertainty, lower interest rates, or less inflation, the value of the investment increases. This combination is precisely what has happened to the stock markets over the past year and a half; an increasing “g” and a decreasing “r”, increasing the value of the investment.

A little more fun with math. Let’s say “g” is the long-term median annual growth rate of earnings of the S&P 500, which is about 8% over the past eighty years. This is not an unreasonable assumption given that economic growth is starting to normalize, which will likely bring earnings growth closer to the long-term trend. With the S&P 500 trailing earnings of $ 175, that equates to an “r” of around 12%. The “r” includes many elements, including future uncertainty, risk-free rate, inflation, and returns.

What if the combination of inflation and rising yields caused the long-term “r” to drop from 12% to 13%? If nothing else changes, the S&P becomes 3,511. Don’t panic, this is not a forecast, but it highlights the sensitivity of the current market to changes in factors such as the long-term inflation rate. and yields. Fortunately, higher inflation and yields can cause the “g” to go up a bit more (profits are also inflated), helping to offset the negative impact of a higher “r”. Some markets benefit more from this natural compensation, such as those that value more companies that profit from inflation or rising rates – the TSX for example.

**Investment implications**

The markets over the last 18 months have really benefited from a rising “g” and a falling “r” – a very powerful combination. While all markets have benefited, some have increased more than others. Stock markets that are longer or oriented towards growth, are more sensitive to both “g” and “r” and have rebounded more (S&P 500, NASDAQ). The more cyclical or value-oriented markets proved to be less sensitive (TSX, Europe). Yet another reason to consider increasing the weighting of TSX or international stocks at the expense of US stocks.

Now, if you are on our side and agree that the economic recovery loses momentum and normalizes at the same time as yields tend to rise due to a combination of less fiscal / monetary support and inflationary pressures, the trend in both ‘g’ and ‘r’ may be about to shift from tailwinds to headwinds. “Welcome to the jungle” does not seem appropriate; maybe “November rain”.

**Source:** Charts are sourced from Bloomberg LP, Purpose Investments Inc. and Richardson Wealth, unless otherwise noted.

**Twitter:** **@ConnectedWealth**

*All opinions expressed here are solely those of the authors and do not represent the views or opinions of any other person or entity.*.