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As the Dow Jones Industrial average (NYSEARCA:DIA) breaks through its all-time high and the S&P500 (NYSEARCA:SPY) is bumping up against the range, investors want to know: Is this an okay time to keep buying?

To make this assessment, an investor needs to do a relative assessment based on where the market is currently trading. In the case of the S&P 500, the most used conventional model is the PE multiple. It is simple in concept. If you have the data, take the current trading value of the index and divide by the current level of earnings of all the companies in the index to get the PE ratio. Then, you can interpret the ratio relative to current expectations for earnings and possibly relative to where the ratio has been in past similar market conditions to judge whether the market is over or undervalued.

But is this a good way to understand today's market valuation?

Personally I do not use this approach, at least in the present market. On the aggregate, I find a very poor relationship, at least short term, between earnings and the S&P valuation. But the real problem with this model and the current market is the mental gymnastics you need in order to understand what a good "relative" PE multiplier should be in an activist Fed environment.

We are currently in an environment where interest rates are being targeted by the Federal Reserve and being held in a range that is not aligned with the relative PE ratios of the past. Additionally the Fed is entering the market and reducing the supply of investment assets, specifically Treasuries (NYSEARCA:TENZ) (NYSEARCA:SCHR) (NYSEARCA:IEI) (NYSEARCA:IEF) (NYSEARCA:TUZ)(NYSEARCA:SCHO)(NYSEARCA:SHY) and Government Backed Mortgage Securities (NYSEARCA:MBB) (NYSEARCA:MBG) (NASDAQ:VMBS) (NYSEARCA:CMBS) (NASDAQ:GNMA), which is forcing demand to flow to riskier, high duration equity assets. The Fed policy has become a major distorting effect and can lead to bad decisions by an investor who does not have a valuation model for equity long duration assets in which they can assess the risks of the Fed-induced distortions.

A Fed Policy Driven Valuation Model

Currently, I assess the fair value of the U.S. equity market using the S&P as the best proxy available. I have multiple time data series available which I can correlate to the traded price of the S&P. Two variables that are most correlated to the S&P:

  • Aggregate Real GDP
  • CPI Inflation Index

Using these factors to assess the value of the S&P compared to years past to know "where you are" is a good start at adjusting for Fed policy. It gives you a basis to assess the real output of the economy relative to stock prices. It also adjusts for the non-real distortions of monetary policy that lead to inflation that are passed through to asset prices over time.

This simple model, however, does not adjust for the Federal Reserve open market operation policies through time - namely the impact on interest rates. In other words, to account for a Fed world in which they hold rates down by actively buying available assets in the market, you need to have an adjustment factor - a distortion adjustment factor.

The way that I do this is by creating a proxy for the interest rate most relevant to long duration equity investments. In simple terms, I adjust for the difference between the 30 year Treasury Rate in one year versus a previous year.

New Variable: 30 Year Treasury Interest rate basis point differential factor

By applying this factor, the distortion when valuing a long duration investment like the S&P500 index on a relative basis across time is far less. This variable links the model value directly to what the Fed is attempting to control in its policy operations - interest rate levels in the economy.

The S&P Valuation Model

To create this model, start with a point in the past that you want to make a relative comparison. I created a model using a point in the past in which the term structure of rates (meaning the difference between Fed funds, 2year, 10Yr and 30 year) is consistent with where it is today on a relative basis. I also looked for a point in the past when Fed open market operations were much more active.

I found two points in time where the historical term structure was very similar, particularly on the longer end of the yield curve, 1983 and 1977 (see my recent article Investing in 2013 - Remember 1977). I choose 1977 to align the valuation assessment, because it is the last time in recent history when the Fed actively utilized open market operations to control interest rates, and the trading pattern of the S&P leading up to 1977 was very similar. Both years align very well with current year valuations.

(click to enlarge)

The model says that if you bought $102 worth of the S&P Index in 1977 and adjusted it for the real growth in the economy, the inflation we have experienced and the lower overall interest rate environment, it should be worth $1500 today. Voila, that is the level it is trading.

Going forward, using the same historical anchor point, you can use this model by just updating the data points to get the relative adjustment factors for Real GDP, CPI and the 30 Year Treasury.

Investor Information Provided By the S&P Predicted Model

One way to test this model is to see if over time it would have helped you to quickly realize that the major market index was expensive or cheap as an asset to purchase in your portfolio. After all, you want to buy low and sell high, not vice-versa.

I have created a chart that shows the results of this model from 1977 to 2013. During the 70s to early 80s time period, the Federal Reserve was in activist mode in targeting rates. It was only when Paul Volcker took over in 1980 that monetary policy tightened. Through the intermediate period from 1980 to 2008, the Fed switched to primarily managing money supply rather than targeting rates. The Fed intervention, in the form of active operations only in an emergency ,showed up primarily after the market "crashes" which occurred - 1987, and 2000. Starting in 2008, the Fed began targeting interest rates and using QE policies much more forcefully again.

(click to enlarge)

If you examine the data in retrospect, you will see very important investor information provided by the simple S&P valuation model:

  1. From 1977 to 1996, the model predicted that the market was very reasonably priced, and accurately predicted critical turning points. In particular, it signaled when the market was over valued prior to the brief crash in 1987.
  2. The S&P began to trade well above the implied fair value of the model in 1996 to 1999. This is the historical dot-com era which Fed Chairman termed "Irrational Exuberance." The market corrected back to the fair implied value by the model in 2002.
  3. From 2004 thru 2008, the S&P market ran-up above the implied model value again. This time period was marked by the real estate market bubble fueled by excessive leverage, and the model signaled that the S&P was excessively expensive.
  4. The 2008 stock market crash is a well-chronicled point in history, beginning with the Bear Sterns failure in the spring of 2008 and hitting true crisis mode with the Lehman Brothers failure in September of 2008. It is a point in the past 40+ years of history in which the relative value of the S&P and almost all correlated markets truly imploded well below implied fair value of the model.
  5. As of January of 2013, the model shows that stocks have re-trenched to 1500. On a relative basis the index is not over or under- valued. This is an important inflection point for the market.

The big difference from the past when the S&P500 reached beyond 1500 and now is that the Fed has become an active market participant. Its balance sheet is now $2.9T as of February 2013. It is planning to grow the balance sheet by $85B per month in 2013. Money supply is now growing faster than it has in years, in a range of 7.5-10.0%. And the interest rate structure is being held at all-time lows, with rates repressed below the rate of inflation. The "elephant in the room" is the balance of the National Debt, which is over 100% of GNP (constant dollar).

The beginning of 2013 is indeed a more unusual time than we as a country have ever witnessed in the markets.

What's an Investor to Do?

In a Fed-driven world liquid traded assets, such as the S&P 500, can quickly trade beyond the point where they are fairly valued on a relative basis. This is caused by new liquidity being pushed out of certain assets as the Fed buys them, and since there is not a good relative liquid asset available for the re-investment, the money flows into a market like the S&P index. The Fed asset buying operations are currently chasing investors out of relatively low risk or risk-free assets into these types of riskier market assets.

The S&P valuation model I have presented in this article forecasts a finite range of fair values for the S&P 500 in which it will remain a neutral buy as an alternative to other potential assets. The neutral value at the end of Jan-2013 is 1500, and has not changed in February.
The S&P has shown historically that it can trade well above the implied fair market value of the model for up to 4 years. But if it does so, it eventually returns to the predicted fair value or even below, if the "medicine" administered by the Fed is really strong. If this happens, as an investor, you must be ready to assess the risk of buying and holding versus trading into an alternative asset.

Here is what the model predicts in three market scenarios that could be faced over the next 4 years:

  • Low-Growth / No Inflation / S&P Run-up: If the S&P rises well above 1500 and is not supported by real growth, then the run-up should be viewed as a risky expensive trade and eventual sell before the music turns off. Why? Eventually the Fed will change policy to cool the market as it did in 1999 and 2007. If this is the future path, investors beware for downside risk.
  • Low GDP Growth / Inflation / S&P Run-up: If the Fed QE drives risk assets up in value and the economy finally begins to see increased inflation, the model predicts that even if real GDP is weak, the S&P can levitate because of the illusion of increase in asset values. In this case, a decrease in Fed stimulus that lets interest rates chase the move up in inflation will not seriously damage the S&P valuation. This appears to be an acceptable Fed outcome at present, given the composition of the members of the Federal Reserve.
  • Higher Real GDP Growth/ Inflation or No Inflation: This is the best of all worlds for the market, and the model reflects this outcome would result in a faster increase in S&P fair market valuation through time and general increase in rates over time. The higher the inflation, the higher the rate move up. This scenario, however, is currently a low probability event because of the National Debt overhang (See my recent article, "Sequester - Why No Stock Market Panic").

Managing Equity Portfolio Risk Today

In evaluating current equity investments, I encourage investors to become much more selective and search for stocks that characteristically are under-valued presently relative to the S&P and have potential to out-perform going forward. You should also shorten the duration of your overall portfolio by getting paid by the stocks that you invest in - but don't overpay for shorter duration.

If you only trade the index or some other index that correlates, then:

  • Know the market entry point where you will buy, and beyond which you will not, and stick with this strategy. The market model I have presented currently sets that point at 1500 and is more likely to move slightly down than up over the remainder of this year, before trending up early next year.
  • Adjust your view of what the buy point should be going forward as new information comes in with respect to the three variables: Real GDP growth, Inflation and the 30 Year Rate all anchored to a fair value starting point.
  • Keep a watchful eye on what the Federal Reserve is doing.

If you follow this strategy, you will be a smarter investor going forward.

Source: Equity Index Valuation Model For An Activist Fed-Driven Market