(Originally written by Dr. Bart DiLiddo, VectorVest Founder. Revised and updated by Angel Clark, Creative Marketing Manager, VectorVest, Inc.)
Back in September, the problem of Syria, poisonous gas and Obama's "Red Line" popped-up and the potential for armed conflict appeared. President Obama was reluctant, of course, to follow through with the threat to employ military forces in Syria, so he was in a pickle. None other than Russian Prime Minister, Vladimir Putin, stepped-in to save Obama's bacon. It was expensive bacon, however, as Putin rose in prestige and Obama declined. Nevertheless, the market moved higher.
Congress failed to approve a budget for fiscal year 2014 by October 1st, so the U.S. federal government was shutdown partially. After 16 days of bitter bickering between Democrats and Republicans, Congress finally approved a continuing resolution authorizing interim funds for fiscal 2014. As expected, stock prices fell; then surprisingly rose to new highs during this ordeal.
October also featured the beginning of fourth quarter earnings season. The worrywarts were at it again, saying earnings growth would be low or close to zero and stock prices would suffer. I countered these pessimistic views in an essay for VectorVest subscribers, written October 11th, 2013, by pointing out that our analysis indicated that stocks in the S&P500 had an average forecasted earnings growth rate, GRT, of 9%/yr. Now that Q4 earnings season has come to a close, I checked our graph of the S&P500 WatchList Averages and it showed that while Earnings Growth (GRT) did, indeed, edge lower over the past 12 weeks, it has remained very near 9%/yr and as of 1/3/14 has started to rise.
So what else could the worrywarts dream up? Ah, stock prices are too high. We're in a bubble, so watch out. Yes, some stock prices are absurdly high. That's why we calculate a current Value for each and every stock in the database. But you can't draw any conclusions about the market by looking at stocks one at a time. You have to look at the whole universe of stocks. For example, the Price of the VectorVest Composite (VectorVest's market index of more than 8,000 stocks) ended today at an all-time closing high of $35.67 per share. We calculate its value to be $34.25 per share or 4.0% lower. That doesn't reflect a bubble, merely that the market is currently trading at full value. But how is this conclusion arrived at and how can you implement it for yourself?
VectorVest's valuations are derived from a mathematical algorithm that incorporates earnings, inflation and interest. Using a consistent mathematical formula for valuation prevents opinion and 'intuition' from interfering with the facts and allows for more objective analysis.
The focus of VectorVest's formula is on earnings relative to the factors that have positive and negative impact on them. Investors put their money where they think it will give them the greatest rate of return. If P/E ratios of stocks are low and Earnings Yields (EY) is high, money will flow into stocks. If bond prices are low and Interest Yields (IY), are high, money will flow into bonds.
The more fearful investors are, the higher their demand that the potential return on stocks be substantially greater than that of bonds. They want to be compensated for the risks they perceive in stocks. The current EY level of stocks in the S&P 500 is 5.65% and the IY of long-term AAA Corporate Bonds is 3.08%. Investors are demanding a 83% higher yield on stocks than they are on bonds. The difference between EY and IY is called the Yield Premium, YP. Currently, EY - IY = 5.65 - 3.08 = 2.57%.
The relationship EY = IY + YP, lays the foundation for stock, as well as market, valuation.
Since EY = 100/(P/E) = 100*E/P, we can substitute for EY and obtain the equation 100*E/P = IY + YP. Solving for P, gives us P = 100*E/(IY + YP).
Replacing P, Price, with V for Value, gives us V = 100*E/(IY + YP).
Let's see how it works with a single stock, since most investors have a high interest in knowing what their stocks are worth. For this example, we'll use McDonalds (NYSE:MCD) and compare the answer to the one we get with an equation that does not factor the yield premium.
Where the stock = MCD, Date = 01/03/14, E = 5.54 and (IY+YP) = 5.65%, the equation shown above gives us, V = 100*5.54/5.65 = $98.05 per share. The actual closing price of McDonald's was $96.54 on the 3rd, indicating that much like the market, it was fairly/fully valued.
Using a simpler formula that doesn't take into account yield premiums, you can easily see that the valuation would be deceptively high.
Example: E = 5.54 and IY = 3.08%, gives us,
V = 100*5.54/3.08 = $179.87.
I do my share of listening to the stock market geniuses on TV and I read what they have to say on the internet and in the press. Many of them don't have a clue of how to calculate stock value which is a much more impartial, and in my opinion, trustworthy analysis of the market's state. Based on our mathematical models which are a slightly more sophisticated version of the formula above, VectorVest's value analysis of the market is stating that the market is fairly valued rather than in bubble territory and that while stocks are trading high, their average price to value ratio is within reason.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.