Despite overvaluation concerns, the rise in the S&P 500 Index appears to be earnings driven and not speculative. The RPF Model shows that the S&P 500 is undervalued by about 7%, narrowing from the 30% undervaluation estimate that I reported in my September 28, 2010 article and the 20% that I reported on November 8, 2010. This suggests continued opportunities for investors, corporate buybacks, and M&A.
The narrowing of the gap was caused by rising Treasury yields, which drive down predicted levels coupled with an increase in the Index. While continued increases in earnings in 2011 should be expected to drive the market higher, investors should keep a cautious eye on interest rates.
The RPF Model is built on a simple constant growth equation where:
P = E / (C – G)
This formula explains S&P Index levels with good accuracy for 1960 to the present using only the risk free rate, S&P 500 operating earnings and some simplifying assumptions. The chart below shows this relationship since 1986.
click to enlarge images
S&P 500 Index (Actual Vs. Predicted) Month End Data 1986 - Dec. 2010
Just as overvaluation during 1999/2000 is apparent in the chart above, recent undervaluation is also visible. For more background and graphs going back to 1960, you can read my summary of the RPF Model on Seeking Alpha or the full paper on SSRN. The next chart shows predicted versus actual P/E ratios for the same period.
S&P 500 P/E (Actual Vs. Predicted) Month End Data 1986 - Dec. 2010
What It Means Today
Today the model shows that equities continue to be underpriced. Using the current 30-year Treasury yield of 4.55% and TTM S&P operating earnings of $83.67, predicted S&P 500 Index is 1,364 – about 7% above its closing price of 1,276 on Wednesday, January 5, 2011.
The recent decline in predicted value shown in the charts above was driven by the increase in yield on the 30-year Treasury from 4.12% in November. Illustrating the impact of Treasury yields on valuation, the predicted value of the S&P 500 would have been 1,512 with the lower November yield. While continued increases in earnings in 2011 should be expected to drive the market higher, investors should keep a cautious eye on interest rates.
Note: While the market has returned to the levels suggest by the model in the past, it is not always by price adjustments. This could mean that earnings are set to fall or interest rates rise or that the model is wrong or the factors need to be recalibrated.
Disclosure: I am long SPY and am also short 30-year and 10-year Treasury
