John Hussman: S&P 500 Fair Value May Be Below 800 (SPY)

Jun.19.06 | About: SPDR S&P (SPY)

Excerpt from fund manager John Hussman’s weekly essay on the US market:

Though we don't know the exact payment stream that the S&P 500 will deliver from here on out, long-term growth rates for dividends and peak-to-peak earnings on the S&P 500 are remarkably well-behaved and predictable within a narrow range. Using a 6% assumed long-term growth rate of dividends (matching the peak-to-peak historical growth rate of S&P 500 earnings), the index level currently required to deliver a 10% long-term total return to investors would be 652 (the S&P 500 currently trades at 1251.54).

The actual growth rate for S&P 500 dividends since 1940 has averaged just 5.7% annually. Using that growth rate, the implied value of the S&P 500 is just 607. Using more optimistic assumptions, the fastest 25-year growth rate for S&P 500 dividends over the past century has been 6.7% annually. If we assume that growth rate for future dividends, the implied value of the S&P 500 would presently be about 788. Though the higher range of that 607-652-788 area seems about right to me, given other information such as earnings, profitability, and so forth, all of these figures are plausible regions of “fair value” on the assumption of 10% long-term equity returns.

One might scoff that such levels on the S&P 500 would put its price/earnings ratio at about 10, but that is, in fact, about the price/earnings ratio that the S&P 500 has averaged when earnings have been at fresh highs near their long-term 6% peak-to-peak growth trendline (as they are currently). The belief that price/earnings ratios should “normally” be much higher is based on earnings that have typically been well below that peak-to-peak growth trendline. You don't pay rich multiples on peak earnings and record profit margins late in an economic expansion if you want to keep your money...

Last week contained a typical fast, furious, prone-to-failure advance, which should be fully expected from time-to-time in order to clear periodic “oversold” conditions that develop in the market. Unfortunately, when the Market Climate is unfavorable as it is currently, the market can become persistently oversold, so it is generally a very bad idea to try to “scoop up bargains” even on a trading basis in hopes of a short-term “clearing” rally.