The Fair Value Math for the S&P 500

15 times $70 = 1050
1050 minus 10% = 945

This is the fair value math for the S&P 500. An appropriate P/E times a believable operating earnings number (12 months forward – mid 2010) minus an appropriate discount rate (stocks are, after all, a discounting mechanism). Of course, one can debate the inputs and the appropriate discounting time period, but the methodology is flawless.

Embedded in the methodology are elements that should (but often don't) go beyond simple business cycle, industry, and company analysis. Factors such as:

• A new world economic order
• A new financial services business model
• The appropriate amount of government intervention

Factors that I will discuss at next Tuesday’s New York Society of Security Analysts “Market Forecast” luncheon.

Unfortunately, these macro factors are not part of most investors’ toolkits. Beyond how such macro factors will impact the shape of the business cycle, big think subjects (such as, What economic philosophy will be the guiding force now that laissez-faire/cowboy capitalism is no longer the dominant principle?) have no way of being incorporated in your standard research methodology. Beyond the subjective aspects of such information, it is difficult to impossible for many investors to fit a new world economic order, for example, into your standard discounted cash flow model. Put differently, there’s no CAPM for the obvious yet out of the box factors that move economies and markets. Yet, they do matter.

Investment Strategy Implications

By all accounts, stocks are more than fully valued. Only those with the rosiest of glasses can envision earnings and P/Es greater than those listed above. Then again, a return of animal spirits overriding the highly uncertain transitional macro elements noted above is not out of the question – especially with $3.5 trillion* still sitting in near zero percent money market funds.

*A hefty 41% of the market value of the S&P 500

Comments

[TradingHelp...:]

Valuations are like women, their beauty is in the eye of the beholder.

Jul 29 09:11 AM

[Larry House:]

Patience is called for. Make a wish list of good quality, good yielding stocks, and when the market is having sane moments, buy them. This is a time for greater discipline, not greater risk.

Jul 29 10:57 AM

[whidbey:]

The 70 seems rich to me. I think earnings have been "padded by things we know are one time adjustments". I think a more rigorous number might be in the 40 to 50 range given employment and the new savings ethic.

The imponderables are certainly important. The discount rate is likely double yours, but who knows what the Gov't will be forced to do to keep its sales moving up.

The global picture seems to be brightening, but the export sector in the US is not looking better if shipping data is reliable. Finally, what happens when the 2010 tax increases arrive: the Bush cuts expire, the health come-alongs arrive, and the cap and trade compromise which saves little energy, but reprices the current stock.

I think your numbers are nice, but not too sensitive to reality, or the probabilities. Best on your presentation to the analysts.

Jul 29 11:00 AM

[thiazole:]

"This is the fair value math for the S&P 500. An appropriate P/E times a believable operating earnings number (12 months forward – mid 2010)"

Your math is a lot better than most here, but there is still a historical issue to consider. At the end of a recession, companies tend to underestimate future earnings quite significantly (just as they overstate at the beginning of a recession). That is why so many companies are beating earnings estimates even for the 2nd quarter.

Jul 29 01:43 PM

[Nick36:]

According to Barron's, operating earnings is a phony way of looking at earnings. Because, "Operating earnings exclude write-offs, while reported earnings include write-offs.... Using operating earnings is now like playing in a golf tournament that doesn't count any penalty strokes for hitting the ball into a water hazard or out of bounds."
online.barrons.com/art...

Reported earnings are the actual earnings that companies can put in the bank or pay out to their shareholders as dividends. And according to the reported earnings so far, the present P/E Ratio of S&P500 is an astounding 723!

This P/E of 723 is so astounding because the previous all time high P/E for S&P500 was 46.
www.safehaven.com/arti...

Jul 29 03:00 PM

[Rokjok777:]

one problem: a 15X multiple is way above the mean. Stocks are "cheap" when multiples are single-digit. Given the pitiful state of worldwide demand, the rampant tricks, insider deals, collusion, off-balance sheet tricks, and "quantitative easing", a 15x multiple seems pretty rich.

Jul 29 05:49 PM

[Mistrofan:]

I very much prefer to use the Net Profits and NOT the Operating Profits. And in that case Fair Value equates to 780 based on my assumptions.

Jul 30 08:58 AM

[ksmithdc:]

Agreed, re with Rick 36.

Jul 30 12:47 PM

[TCK:]

This rally is reminding me of the market bubble in 1999. Economic news and earnings reports are "spun" into positive news, P/E ratios ignored, "Pro Forma" earnings are back, and stocks continue to rise on momentum alone.

How much longer will it last before 30% down ?

Jul 31 08:16 AM