S&P500 (NYSEARCA:SPY) is at around 1820 at the time of this writing (February 12, 2014). Based on Professor Stephen Penman (Columbia Business School) books and teachings, I am doing an analysis challenging S&P500 at these levels. In the past years 2007, 2008 and 2011 this study has yielded excellent results as a result of which I rely on this model to value the market. Current S&P500 book value, 2014 forward earnings were obtained using multiple sources (Barrons, WSJ, Yardeni Research). It is listed in table 1. Most of the sources are projecting S&P 500 companies to earn $120 in 2014. Current book value is at 667.
Table 1: Assumptions for S&P500
Using the residual earnings model, one can solve for implied earnings growth, for a given level of S&P500 index. The required return for equity holders is 9%. Implied earnings growth is then compared to a GDP growth rate that is around 3.5% (or 4% if one is optimistic). Table 2 shows the implied earnings growth rate for various levels of S&P500.
Table 2: Implied Earnings Growth for S&P 500 at 4 levels
One can compare these implied earnings growth rate to recent GDP growth rate (assumed at 3.5%) to see if index is overpriced, fairly priced or underpriced.
Table 3 shows the implied earnings growth for a given level of S&P 500 index level and compares it to 3.5% GDP growth rate. At 1820 S&P is trading slightly ahead of expectations.
Summary: S&P500 maybe range bound from 1700 to 1850 this year. If the index shoots up to 1950 then certainly it might due to market participants pricing high growth in GDP (positive surprises in the economy) or an asset bubble forming as participants chase returns in an up-trending market. On the downside, I am buyer of the index at 1740 or below.
Table 3: S&P500 at 1820 is trading slightly ahead of expectations