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Stephen D. Hassett is a technology executive with economics as hobby. Steve is based in Atlanta, Georgia, and author of "The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices" http://bit.ly/JKtTiE. His RPF Model is based on work he had done... More
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The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices
  • Bubble Talk: It's NOT Different This Time 0 comments
    Mar 7, 2014 2:23 PM

    One reader of my last article commented, "Anybody who says 'it's different this time' needs to be woken up. And you can do all the charts you want to show whatever you want the market remains unpredictable."

    My assertion that we are not in a bubble is not that it's different this time. It is the same this time. Record highs are not different; the market has closed at record high more than 800 times since 1960. The market actually continues to be predictable in its response to certain factors. In the introduction of my book, "The Risk Premium Factor," I say:

    "The notion that the market is a mysterious arbiter of value, when, in fact, it is easy to understand and almost reptilian in response to readily observable factors. Reptiles respond in very predictable and instinctive ways using their small brains. Surprisingly, so does the market, and it's all linked to some deep-rooted psychological behavior called Loss Aversion uncovered by Daniel Kahneman and Amos Tversky in the late 1970s (Kahneman won the Nobel Prize). This book exposes the market's small brain and introduces a very simple (small-brain) model that shows that the market responds to just three factors: earnings, long-term growth, and interest rates."

    The Risk Premium Factor Model exposes the simplicity. The chart below compares actual to predicted levels since 1960.

    (click to enlarge)

    The story continues to be the same. The S&P 500 is currently fairly valued with higher long-term bond rates already factored in. Fairly valued means that investors can expect annual equity returns of about 11%.

    The S&P 500 closed at 1,877 on March 6, 2014. While this is a new record closing high, record highs are not rare. The S&P 500 has closed at a record high over 800 times since 1960 - that's about once every 16 trading days. Bubbles are rare, record highs are expected.

    The RPF Model

    The Risk Premium Factor Model (RPF for short) is used to determine the intrinsic value of the market to help identify bubbles or buying opportunities. (If you are a regular reader, the inset material below will be familiar.)

    Determining whether the market is fairly valued is a simple matter of looking at its price relative to earnings and the P/E ratio. The Risk Premium Factor (RPF for short) Model shows that the fair value P/E ratio at any point in time is determined relative to long-term interest rates and not based on a simple historical long-term average as some would argue.

    In short the model says that:

    Intrinsic Value of the S&P 500 Index =

    S&P Operating Earnings / (Long-Term Treasury Yield x 1.48 - 0.6%)

    The model shows that equity prices (NYSEARCA:SPY) move inverse to yield. In this simplified version of equation, 1.48 is the Risk Premium Factor and 0.6% is the difference between long-term expected growth and real interest rates. I've written about the model numerous times, so rather than repeat my entire overview of the model, you can read about it in my book or on Seeking Alpha where you can find the expanded equation as well.

    Today it shows that the S&P 500 is fairly valued, not in a bubble and priced for continued growth with higher long-term bond rates already factored in. Fairly valued means that investors can expect annual equity returns of about 11%. This is a long way from a bubble.

    Using a rough estimate of a normalized long-term interest rate of 4.5% (2% real plus 2.5% inflation) to adjust for the Federal Reserve's artificially depressing long-term rates by keeping short-term rates near zero, the model shows the S&P 500 is fairly valued. (If you care to read my past articles, they indicated that the S&P 500 was undervalued.)

    Alternatively, the RPF Model implies the fair value yield on 10-year Treasuries is 4.33%.

    The chart below shows predicted versus actual levels of the S&P 500 Index since 1986. Bubbles are indicated by periods where there is a large gap between predicted and actual levels. This also illustrates the strong historical performance of the model compared to the actual - continuing to revert back to predicted levels.

    (click to enlarge)

    The chart uses normalized yields on Treasuries of 4.5% (2% real plus 2.5% inflation) from August 2011 through the present. It shows the recent several year period where the S&P 500 was significantly undervalued.

    Today the model shows that the market is slightly overvalued based on trailing earnings and the implied 4.5% 10-year yield. Given 4.5% is a very rough estimate, I would not use it to make a granular valuation call and consider the market fairly valued today.

    This also means that higher long-term rates are already factored in. Of course they are. From a valuation perspective, everyone knows that at some point soon the Fed will cease its bond buying program and long-term rates will float freely. Investors price stocks today based on future expectations. They know rates will rise (but not exactly when) and have priced stocks prices accordingly. The intrinsic value based on today's actual long-term rates would be 28% higher.

    It is possible that rising rates will have other direct economic consequences as mortgage rates rise making housing more expensive and companies pay more for borrowing. There is also a positive as consumers benefit from higher rates on their savings. I don't know how those factors will impact the economy and earnings. I expect that, they too, are already priced in. One value of the RPF Model is allowing you to test various scenarios for rates and earnings.

    What does this mean for equities long term?

    The model calculates expected returns (cost of equity) as Long-Term Treasury yield + Equity Risk Premium, where the Equity Risk Premium equals Long-Term Treasury yield times the Risk Premium Factor. That is, 4.5% + 4.5% x 1.48 = 11.6%. At fair value, the market can be expected to yield at total return of 11.6%.

    Using the S&P's forward estimates for operating earnings and assuming long-term rates stay at 4.5% or less, the RPF models show considerable upside for year-end 2014.

     

    S&P 500
    Operating
    Earnings

    Index
    Actual

    Index
    Predicted

    6-Mar-14

    109.23

    1,877

    1,802

    31-Dec-14

    121.73

    Estimated

    1,992

    The market is currently valued the same way it has been for at least the past 50 years. It's the same this time.

    Disclosure: I am long SPY.

    Additional disclosure: and short long-term Treasuries

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