The Risk Premium Factor (RPF) Valuation Model indicates that the S&P 500 (SPY) is fairly valued today but has significant upside based on projected earnings.
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 the S&P's trailing twelve month estimated earnings of $99.30, the intrinsic value of the index is 1,644 - compared to the August 28, 2013, close of 1,635. What's more, based on the S&P's projection for 2013 and 2014, the intrinsic value of the S&P 500 would end 2013 at 1,958 and end 2014 at 2,017.
S&P 500 Operating Earnings
Of course, this is completely contingent on both earnings meeting projections and interest rates remaining 4.5% or less.
While fairly valued now, the RPF model showed that the market had been undervalued by over 25% in parts of 2010 and 2011. Some argue that the market is overvalued today. The potential validity of their argument is dependent on the underlying reasoning. Those who 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.
Additional disclosure: and short long-term treasuries