For the first time since the financial crisis, the Risk Premium Factor (RPF) Valuation Model shows that the S&P 500 (NYSEARCA:SPY) is now fairly valued.
The market is fairly valued… what a dull headline. I've been writing for Seeking Alpha since September 2010, and first published my model in the Journal of Applied Corporate Finance in July 2010. If you have read my previous articles, you might think that I am a perma-bull. That's not the case. It is simply the fact that the RPF Model has shown the S&P 500 to be undervalued until now. Since they are closely correlated, this also applies to the Dow (NYSEARCA:DIA) as well.
Let's be clear -- fairly valued does not mean overvalued. It means that if the economy remains stable, long-term interest rates remain under 4.5% (more on this below), we can expect long-term growth in earnings for the S&P 500 to continue, affording companies the ability to invest, pay dividends and buyback shares. This would result in an expected return consistent with the equity cost of capital of about 11%.
The RPF Model is a simple approach for understanding intrinsic value of the market. The model shows that two factors drive the market, earnings and long-term interest rates, which drive cost of capital and embody inflation. And for individual companies, a third factor: growth. The RPF Model shows for a given level of earnings and long-term interest rates whether the market is over or undervalued.
This series of articles provides periodic updates to compare predicted to actual based on the latest earnings, interest rates and actual S&P 500 Index values. I've written about the model numerous times, so rather than repeat my overview of the model, you can read about it on Seeking Alpha.
The chart below shows actual versus values predicted by the RPF Model for the S&P 500 since 1986.
The chart uses normalized yields on 30-year Treasuries of 4.5% (2% real plus 2.5% inflation) from August 2011 through the present to adjust for the Federal Reserve's artificially depressing long-term rates by keeping short-term rates near zero.
This suggests that if you expect earnings to hold at the current level or increase in the coming year, the market is fairly valued. Today, the model shows that with a normalized yield on 30-year Treasuries of 4.5% and using S&P's trailing twelve month estimated earnings of $98.34, the intrinsic value of the index is 1,623 -- compared to the May 30, 2013 close of 1,630.
Since the model shows that stock prices move inversely to long-term Treasury yields, using the actual 3.13% yield on the 30-year would result an even higher predicted price for the S&P 500.
The gap that had been well over 25% in parts of 2010 and 2011 has closed as equity prices have increased. Some argue that the market is overvalued. The potential validity of their argument is dependent on the underlying reasoning. Those that suggest the market is overvalued because fundamental economic problems that could hurt earnings are making their case based on fundamental principles: if the economy weakens and earnings fall, the market should follow, or if inflation increases, P/E ratios should fall.
Others make a naive argument that the market is overvalued simply because it has increased and hit a new high, so it is due for a correction. Of course the market could decline, but not simply because it has increased. As I explained in my book, all previous bubbles bursting can be explained by the fundamentals of earnings and interest rates.
Disclosure: I am long SPY and short long-term Treasuries. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.