Stockfoo/iStock via Getty Images
The Vanguard S&P 500 ETF (NYSEARCA:VOO) gives investors a convenient and low-cost method to gain exposure to equities. However, persistent inflation and ratcheting interest rates suggest the S&P 500 Index and the VOO exchange-traded fund (“ETF”) may have more near-term headwinds.
Fund Overview
The Vanguard S&P 500 ETF invests in stocks in the S&P 500 Index, which represents the 500 largest U.S. companies. Vanguard’s ethos is built upon two simple but powerful ideas:
Owning the stock market over the long term is a winner’s game, but attempting to beat the market is a loser’s game.
The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.
– Quotes from Jack Bogle, founder of Vanguard
While investors can debate the validity of the former statement, there’s no debate that fees and costs are detrimental to long-term returns. Vanguard funds, in general, have some of the lowest expenses in the market. The VOO ETF has an expense ratio of just 0.03%, the lowest amongst peers.
Figure 1 – VOO profile relative to peer funds (Seeking Alpha)
Stellar Historical Performance
As the VOO ETF tracks the S&P 500 Index, it’s historical performance is basically that of the broad large-cap U.S. equity market, less fees and tracking error. With the exception of the brief COVID-19 market meltdown and 2022 to date, the past decade has been generally good for equities, with the VOO ETF and the S&P 500 returning annual returns of 13.0% and 13.1%, respectively.
Figure 2 – VOO historical performance (vanguard.com)
Distribution & Yield
The VOO ETF pays a market-like distribution yield of 1.6%. The distribution is variable and dependent on dividends from the underlying companies. It pays a quarterly distribution and the last distribution of $1.4321 / share was paid on July 5th, 2022.
Soaring Inflation Suggest Stocks Have More Downside
Although the VOO ETF and the S&P 500 have had stellar historical performance, recent persistently high inflation readings have placed future stock returns into question.
When we look at inflation, we see that the S&P 500’s real earnings yield (inverse of P/E multiple less CPI inflation), is at the lowest level since the late 1940s (Figure 3), even factoring in the ~20% YTD decline.
Figure 3 – S&P 500 Earnings Yield vs. CPI (yardeni.com)
Past episodes when the S&P 500’s real earnings yield dipped into negative territory have coincided with bear markets (shaded areas on the chart), and/or a sharp rise in earnings yields (P/Es decreasing). This makes intuitive sense because investors will not willingly hold an asset that earns less than inflation. They will reprice the asset until its earnings is greater than inflation.
Historically, the S&P 500 has a long-term average real earnings yield of 3.19%. For the S&P 500 to return to the average from its current -4.49% reading, a combined decrease in CPI inflation (latest reading was 8.3% YoY) and/or increase in the S&P 500’s earnings yield by 7.68% is required. If this adjustment were to come solely from P/E contraction, the S&P 500’s trailing earnings multiple will need to contract from 24.1x (4.15% nominal earnings yield) to 8.5x (11.83% nominal earnings yield).
Figure 4 – S&P 500 Long Term Average Earnings Yield of 3.19% (yardeni.com)
Granted, inflation is likely peaking and the S&P 500 earnings yield is unlikely to go to 11.8% (P/E dropping to 8.5x is unlikely because even after the Great Financial Crisis, the S&P 500’s P/E only dropped to 12-14x). However, it does suggest the path of least resistance is for lower stock valuations if inflation persists.
Interest Rates Also A Headwind
Another related headwind investors need to consider is the tools central banks like the Federal Reserve are using to combat high inflation. Central banks control monetary policy, i.e., they determine the amount of money and credit that is available in the economy by setting interest rates. Since the beginning of the year, the Federal Reserve has increased the Fed Funds rate by 2.25%, and is widely expected to raise interest rates by another 75 bps at the upcoming September FOMC meeting (Figure 5).
Figure 5 – Fed Funds Rate (tradingeconomics.com)
Higher interest rates can have large negative impacts on equity prices. First, higher interest rates mean higher interest burden, leading to decreasing incomes. Second, equities are essentially claims on a company’s future cash flows. When interest rates rise, the “present value” of these future cash flows decrease. Incidentally, the rise in interest rates has caused an epic collapse in many growth stocks because most of the value in high growth companies are far out in the future and are very sensitive to discount rates. Finally, by increasing interest rates and tightening monetary policy, the Federal Reserve reduces the amount of money and credit that is available to buy investment assets like equities.
Historically, there is a very strong relationship between the S&P 500’s earning’s yield and treasury yields (Figure 6).
Figure 6 – S&P 500 Earnings Yield vs. 10 Yr Treasury Yields (yardeni.com)
As investors increasingly expect the Federal Reserve to continue raising interest rates to higher terminal rates, we should expect equity valuations to continue to decline (Figure 7).
Figure 7 – investors continue to expect higher terminal rate (Reuters.com)
Conclusion
While the Vanguard S&P 500 ETF is a fine choice for investors looking for low-cost exposure to large-cap equities, investors are cautioned that persistently high inflation and ratcheting interest rates suggest the S&P 500 and VOO ETF may have more near-term headwinds.
Be the first to comment