S&P 500 Nears Record High But Risk Premium Factor Model Shows It's Still Undervalued

Includes: SPY
by: Steve Hassett

The S&P 500 (NYSEARCA:SPY) Index is approaching a record high, up by 5.1% this year and 19.2% since start of 2012, yet the Risk Premium Factor (RPF) Valuation Model shows that the index is still undervalued by about 7%.

The RPF Model is a simple approach for understanding intrinsic value of the market. The model shows that two factors drive the market, earnings and long-term interest rates, which drive cost of capital and embody inflation. And for individual companies, a third factor: growth. The RPF Model shows for a given level of earnings and long-term interest rates whether the market is over or undervalued.

This series of articles provides periodic updates to compare the predicted to actual based on the latest earnings, interest rates and actual S&P 500 Index values. I've written about the model numerous times, so rather than repeat my overview of the model, you can read about it on Seeking Alpha.

The chart below shows actual versus values predicted by the RPF Model for the S&P 500 since 1986.

(Click to enlarge)

The chart uses normalized yields on 30-year Treasuries of 4.5% (2% real plus 2.5% inflation) from August 2011 through the present to adjust for the Federal Reserve's artificially depressing long-term rates by keeping short-term rates near zero.

This suggests that if you expect earnings to hold at the current level or increase in the coming year, the market is undervalued. Today, the model shows that with a normalized yield on 30-year Treasuries of 4.5% and using S&P's trailing twelve month estimated earnings of $97.51, the intrinsic of the index is 1,609 - 7.4% above the January 31, 2013 close of 1,498. Since the model shows that stock prices move inversely to long-term Treasury yields, using the actual 3.17% yield on the 30-year would result an even higher predicted price for the S&P 500.

Over the past 50 years, the market has consistently reverted to the values predicted by the model, which suggests that something has to give. Any combination of the following could restore parity:

  1. We enter into a double dip recession and earnings on the S&P fall by about 6.5%
  2. Long-term rates move much higher, bringing the yield on the 30-year to 4.8%
  3. Equity prices increase

The gap has been closing as equity prices have increased. Some argue that the market is overvalued. The potential validity of their argument is dependent on the underlying reasoning. Those who suggest the market is overvalued because fundamental economic problems such as the deficit, increased tax rates or reduced government spending could hurt earnings are making their case based on fundamental principles: if the economy weakens and earnings fall, the market should follow; if inflation increases stock P/E ratios should fall.

Others make a naive argument that the market is overvalued simply because it has increased, so it is due for a correction. Of course the market could decline, but not simply because it has increased. As I explained in my book, all previous bubbles bursting can be explained by the fundamentals of earnings and interest rates. They did not burst simply because prices increased. I advise tuning out those voices and paying attention to the drivers of the market rather than its momentum. Over the long-term it has shown to respond to interest rates and earnings. Focus on those factors and develop a view on their direction, then use that to gauge the market.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: and short long-term Treasuries