US housing market and consumer confidence are key for equity valuation
When we set out to build an earnings yield model on S&P 500 our aim was to find the factors that can explain the variation in the earnings yield. Our first model was using mostly aggregate company fundamentals on the S&P 500 such as EBIT margin, revenue growth, capex-to-sales etc., with the 12-month trailing earnings yield as the target in the model. This model was misspecified for several reasons including the 12-month trailing earnings yield being too volatile and lagging, but more importantly company fundamentals on the S&P 500 are economically related to earnings and thus not offering an interesting model driven by external variables from the companies themselves.
In the final model, we switched from aggregate fundamental data to time series on the US economy or financial markets other than the equity market. We also changed the earnings yield from 12-month trailing to 12-month forward because this variable is more stable, and the forward-looking nature of the variable is also more interesting and how the equity market operates. We started out with a simple linear regression, but since we are modelling the earnings yield and not changes in the earnings yield we could not get rid of the autocorrelation in the residuals, which is a key violation of the linear regression model assumptions. We therefore ended up with a random forest model which is a less strict model in terms of assumptions of residuals and the underlying distribution of the data. Our final model consists of 25 features describing different aspects of the US economy and financial markets.
From the random forest model we can compute the feature importance and based on the model output the features (ordered with the most important at the top) below are the ones that explain 50% of S&P 500 12-month forward earnings yield. The two most important features are the NAHB Index taking the temperature in the US housing market and consumer confidence. These two indicators remain currently above their historic average, but both are at risk with tighter financial conditions (and higher mortgage rates) and rising inflation putting pressure on consumers. The third most important feature in explaining the S&P 500 earnings yield is the yearly change in US home prices. In other words, the US housing market is very important for US equity valuations.
- National Association of Home Builders Market Index
- Conference Board Consumer Confidence
- S&P CoreLogic Case-Shiller US National Home Price Index YoY
- US Avg Hourly Earnings Private NFP YoY
- Fed M2 YoY
- US U-6 Unemployment Rate
- Net % of Domestic Respondents Tightening Standards on loans for Large companies
- US 2-year yield