This article shows 12/16/11 updates of Required Yield Theory (NYSEARCA:RYT) valuation models for the SP500, gold and oil. Key recent events that may impact valuations are summarized first. Relevant comments that may interest investors accompany the graphic representation of each valuation model.
- ECB (European Central Bank) accepts low(er) quality “assets” for expanded mainly USD$ lending to its generally insolvent (according to free market standards) and illiquid large banks. This provides a partial and temporary liquidity backstop.
- The Fed says no “bailouts” by it of Europe … but unlimited USD$ swap lines to the ECB are OK
- The real yield as measured by Treasury and TIPS markets has declined week to week
- As have inflation expectations in U.S. markets. I suspect, but do not measure, that global inflation expectations have dropped even more so due to relatively worse growth and liquidity outlook than that of the U.S.
- The CPI-PPI gap narrows, adding further pressure to U.S. corporate margins with evidence mounting of increasing retail discounting and high return rates, import prices falling, real incomes stagnant, USD$ index up (which reduces the value of foreign earnings conversion), and top and bottom line pressure for similar but more pronounced reasons for the 50% or so of SP500 EPS coming from off shore operations.
- The ratio of the 10 year corporate single A rated bond yield index to the 10 year treasury (a measure of private credit risk) is at levels comparable to those of mid to late September, 2011 and April, 2009 (the latter bookend of the infamous 10/2008 – 4/2009
- Outlook Note: the U.S. growth outlook is the only factor holding world stock and commodity markets together. The moment this softens, look out below for oil, gold and stocks while seeing handsome gains from zero coupon and long term Treasury prices. Avoid risky debt such as corporate and muni issues if you, as I do, expect this scenario to unfold in coming months despite the positive reports this week from the NY and PHL regional Fed banks’ economic activity indices. (The reason gold will drop in this scenario is because of collapsing inflation expectations overwhelming the supportive effect of lower real yields on capital – see below and in the article links for a more complete explanation).
According to RYT valuation models, respectively: a lower real yield is: a) positive for gold, bond and oil prices and negative for stock market valuation and bond yields; b) lower inflation expectations reduce bond yields/increase prices, decrease the value of gold, increase the valuation of stocks and have minimal impact on oil price; c) the rising USD$ index e.g. DXY is negative for oil and gold and indirectly negative for stocks via reduced repatriation value of foreign earnings. RYT valuation descriptions on SeekingAlpha may be found under the author's article listings.
The unprecedented valuation accuracy of these models continues. There are no public domain valuation models that come close to the empirical accuracy of the RYT models (including the “Fed Model” in its heyday – see my referenced paper published through NYU in the stock market valuation article link for proof of this); nor in the theoretical substance that underpins them.
The SP500 remains modestly over-valued (by 5-6%) and very exposed to any weakening in U.S. growth prospects, those of the EU and/or China. As noted above, any massive QE by the ECB will drive U.S. and foreign equities higher in the short term.
As I noted in my SeekingAlpha article (link above), being long DUST (the leveraged inverse gold miner ETF) would be fruitful as of 11/21/11. DUST is up 14% since then. Gold has currently fallen below the model valuation. However, the model currently uses only U.S. expected inflation rates (lower expected inflation is negative for gold). I believe expected world inflation is falling much more than U.S. inflation expectations and that, absent ECB QE through monetization, intermediate term prospects for gold are negative.
WTI crude prices continue to follow the model and my prior expectations down, yet hold a sizable Iran-Egypt supply interruption risk premium due to external and internal tensions. As world growth expectations ratchet down, again, absent major monetizing QE by the ECB, oil’s intermediate term prospects are negative; contrary to Goldman’s forecasts. Those who believe likewise may consider investment in leveraged inverse ETFs such as SCO, ERY and RUSS (RUSS is very sensitive to oil prices). It is worth noting that the Russian ministry of commerce issued an oil price warning last week.
Enhanced RYT models are patent-pending, unpublished, and available selectively to investors pursuant to a NDA. Public domain RYT models found in published academic papers and patents are patented in the U.S. and must be licensed prior to use in computerized applications including spreadsheets.
Conclusion and Disclaimer
The content offered here represents a comprehensive theoretical and empirical basis for the valuation of stocks, bonds, gold and oil that the author believes cannot be found elsewhere. Required Yield Theory forms the basis for all of the models and asserts that all mentioned assets are valued in relation to an empirical and theoretical constant currently not recognized by mainstream Finance: long term, real, global per capita productivity growth of about 2%.
Nothing herein shall be construed as investment advice. Investors must form their own opinions and prudently manage risks. Content presented here is solely the view of the author.
Intellectual Property Notice
Required Yield Theory ™ and RYT ™ are trademarks. Required Yield Theory is patented in the U.S. under two patents (U.S. 7,725,374 and allowed Serial No. 12/766,956); is also patent pending under several applications; and patent-pending in the EU and other political jurisdictions. Public domain formulas may not be used in computer applications without license from the author. Asset managers wishing to learn about the applications for gold, stock, bond and oil valuation may contact the author through the RYT website . Formulae and data will be provided under NDA for evaluation.