Markets are sometimes volatile. The past five years have been a wild ride. As investors, we naturally believe that markets are efficient at discovering price (the value of things), but volatility of the kind we have seen since 2007 throws a massive monkey wrench into that theory. Given that actual future events introduce massive error to predictions about the future (technical analysis always looks good going back in time), how can we get a firm handle on what the price of the S&P SPY should be?
Many investors look at P/E. According to P/E, stocks are right in line with the long term avg P/E ratio, but as pointed out in this article, 2009 saw very high P/E ratios (image from www.multpl.com below), which was precisely the time to buy, so to say that one should buy stocks when P/E is low and sell when it is high is not always good thesis.
As a physical scientist, I like to think about real stuff, like fuel. Both electricity and gasoline consumption (source www.eia.gov) have risen steadily throughout the 20th century until the present in America.
These charts look like good news. It says that economic growth is occurring steadily. Amazingly, the same charts for world electric consumption are increasing at a comparable pace - meaning that the US is just as strong of a growth engine as any "developing" nation.
My hypothesis is that these measures of growth are an excellent benchmark to use to determine what the long term value of the S&P should be during an extended period of high volatility. However, since we are trying to calculate prices, we must also look at what has happened to the value of "1" over the long term. That is to say, what is the inflation rate? Now, because neither I nor the Fed knows what the Fed is doing or what the effect of its action is, I will focus on something I do understand - dollar bills. According to the St. Louis Fed, our money supply (the amount of currency in circulation - which I consider as solid a measure of inflation as anything else out there) has doubled every ten years since 1970, - which translates to about 7.2% per annum!
The long term rate of growth in the money supply outpaces or is comparable to the growth in actual energy consumption since 1970. Taking the price of gasoline in 1970 ($0.35/gal) and assuming that price doubled four times since then, gasoline should be worth about $5.50/gal. Today gasoline is worth only $4 despite growing demand for the amber liquid. The price of the S&P 500 was about $90. Monetary inflation alone says that the S&P should be worth about $1400 and that's where we are finding resistance today! This exercise leads to only one conclusion: The stock market is insanely undervalued! $1400 on the S&P assumes that aside from dividends paid, the economy didn't grow at all! Not only that, gasoline is no more sustainable of a resource today than it was in 1970, but is trading like people view it as cheap and plentiful.
So what's going on? I would argue that company earnings are not increasing as fast as the money supply because the increased money supply is not getting into the hands of the consumer. Because the consumer is so poor, prices of both goods and basic services are lower than expected, earnings are lower than expected, and so the price of equities are lower than expected. Even if these structural problems persist, the stock market still looks insanely cheap. In terms of the price of gold, the S&P looks undervalued and could easily double in the next upswing but that is small consolation for the following thought: If energy consumption growth and equity prices were directly correlated and equal in magnitude and the government didn't print any new money between 1970 and 2012, the S&P would have a fair value of $1400 AND gasoline would cost $0.35/gal or less. Alternatively, if we also factor in the money printing, the S&P would be at ~20,000 and gasoline at $5-6/gal. The only conclusion I can take away from the last thought experiment is that money printing killed the bull. The sooner we can get the politicians to put a stop to that the better our futures will be.
Although the markets look undervalued in the long term big picture, there could still be a lot of downside volatility ahead, so this is certainly not a BUY BUY BUY call, just a thought experiment.
Additional disclosure: I have long positions in stock of companies not explicitly mentioned in this article. Some of those stocks are included in the S&P 500 but I do not own shares of the SPY ETF or any other market index.