The Question of Value Is Relative: SPY as an Example

Whether something is cheap or expensive depends entirely on the financial situation of the person asking. A $40,000 sports car is expensive to a family that brings in the average median income each year. For someone with a nine figure net worth, $40,000 may be a somewhat trifling sum, and for him or her, a $40,000 sports car is cheap.

When it comes to spending, most of us get it about how value is all relative. So why not when it comes to investing? I can’t tell you how many articles are floating around there seeking to address the question of whether stocks are, in some absolute sense of the term, “cheap” right now. The question is entirely pointless if you believe that something’s value precisely equals what someone in the marketplace will pay for it, and seems even more pointless if that someone in question is you in particular. I mean, who cares whether someone else is willing to buy an SPDR S&P 500 ETF (SPY) at Tuesday’s closing price of $85.27? That guy might be a complete idiot, or maybe his financial situation is entirely different from yours. Either way, it’s really none of your business, and why spend your life running around worrying about what other people are doing or buying?

So if the question of value is relative, what are the two factors investors should weigh in making a decision whether or not to invest in the stock market at any given moment? The answer is this: (1) what you can afford, in terms of time; and (2) what are your opportunity costs.

And how do you quantify that? Simple. Let’s use SPY as an example. On September 30th, 2008, State Street Global Advisors reports that SPY had a book value of about $53 a share. That means that if I buy SPY at Tuesday’s closing price of $85.27, I’ve immediately made back $53 of my investment, and I’m about $32.27 in the hole. The first question I need to ask myself is this: how long until my investment pays for itself with earnings?

Here is where the analysis gets a bit more complex, because earnings, like stock prices, are volatile. As of the end of last September, State Street Global Advisors reports that SPY then had FY1 earnings of about $9.23 a share. So, assuming earnings grow at about 7% each year (which is about average for the S&P 500 on a pre-inflation adjusted basis), that means it might take me about three years for my investment to pay for itself. If I’ve got three years to hold the investment, then buying SPY at $85.27 satisfies my first criteria because I have the time to afford SPY at this price.

You know, it pays to be a bit conservative when you run this calculation because corporate earnings are volatile. In Jeremy Siegel’s recently published article “Why Stocks Are Dirt Cheap”, he points out that Standard and Poor’s projects 2008 operating earnings for the S&P 500 to be around $64 a share, and reported earnings of around $49 a share. He also points out that the average earnings per share in the U.S. stock market since 1872 produces a mean value of $56.40 on the S&P 500. Earnings of $56.40 may understate the true earnings on the S&P 500 due to the fact that dividend payouts have decreased dramatically since 1981 and firms have, on average, been reinvesting capital to produce higher growth.

But when I consider investing in SPY at $85.27, I should understand my “worst case” scenario in terms of earnings. So, I will assume that SPY earnings will drop over 40% all the way down to the historical mean value of $5.64 a share, and I will assume corporate earnings growth will drop to 0% a year for the immediate future. On these harrowing assumptions, it’s going to take me about five and a half years for my investment in SPY to pay for itself. If I have five and a half years, I can afford SPY. If I have more than five and a half years, this looks like this investment could be one heck of a gravy train.

But wait. Now I need to consider whether this particular gravy train is the best one I have the opportunity to ride. If I’m lucky, I might have opportunities to invest in high yielding real estate, or private businesses. Unfortunately for me, I don’t have enough capital for that, I don’t have the time, and I am not all that sophisticated. I’m basically stuck between stocks and bonds. So guys like me I need to look at my opportunity cost by comparing the earnings yield on SPY with the yield on a ten year US treasury – which means, I am going to apply the “Fed model” to my own personal financial circumstances. The Fed model generally holds that over the long term, the earnings yield on equities should be about equal to the yield on a ten year US Treasury. True, Treasuries are less risky than stocks, but corporate earnings tend to grow, whereas interest payments on a US Treasury do not. Based on the Federal Reserve’s research, it turns out that on average, the higher earnings risk on stocks tends to be cancelled out most by the greater opportunity for earnings growth. When that hasn’t been true, and the earnings yield on stocks is higher than the yield on a ten year US Treasury, stocks tend to fall, and when earnings yields on stocks are lower than the yield on a ten year US Treasury, stocks tend to rise.

So I divide the FY1 2008 earnings on SPY by yesterday’s closing price and get an earnings yield of almost 11%. When I compare that with the yield on a ten year US Treasury (which, as of yesterday stood at 2.8%), I see that I can earn almost 400% more in stocks than bonds. Needless to say, a 400% earnings premium on stocks is pretty sweet – actually, it’s probably unheard of, historically speaking. It almost seems too good to be true, so I’m going to check out my “worst case” scenario – going with earnings of 5.63 on SPY instead. With that lower earnings figure, I get an earnings yield of about 7% at yesterday’s closing price – which is not quite a 300% premium but even that is historically about as good as it gets – we’ve only seen that kind of premium at the bottom of the 1970s bear market and following the crash of 1929. And what if the interest rate on a ten year US Treasury snaps higher by 50%? Well, I’d still be getting almost a 100% premium on SPY, which is enough that I won’t even consider investing in US Treasuries. If, however, the yield on US Treasuries explodes up by a few hundred percent, or corporate earnings drop another 80% or so, I might become somewhat ambivalent as between stocks and bonds. But in terms of whether I should prefer SPY over bonds today, it’s no contest.

I’m not going to even try to answer the question of whether stocks are, objectively speaking, cheap or not. I don’t care. All I need to know is that if I have a few years, the market will pay me the largest risk premium for owning SPY than I’ve ever seen before, and to the extent I care about value when I buy capital, buying SPY today is a vastly good opportunity. Obviously, maybe that opportunity will look even better if SPY drops to $60 a share next week, but since I don’t have a time machine, I have no idea whether I will get an opportunity to buy SPY at $60 or not. But what I do know is that I can get a 300% or 400% premium today, and with a premium like that, it would be pretty greedy on my part to wait for a better opportunity to come along tomorrow.

Disclosure: The author owns SPY and now wants to buy a whole lot more.