Fund manager John Hussman’s newsletter this week brought up what for many would be a frightening prospect: that the current fair value of the S&P 500 Index is 800.
The chart below updates my September 12, 2005 study on the S&P 500 as a discounted stream of future dividends. The blue line is the actual value of the S&P 500 since 1900. The green line is the level at which the stream of S&P 500 dividends (including the implied effect of repurchases) would have actually been priced to deliver a long-term total return of 10% to investors, based primarily on the payments that were, in fact, delivered over time (see the original study for details on repurchases, terminal values, and other explanatory notes).
Though we don’t know the exact payment stream that the S&P 500 will deliver from here on out, long-term growth rates for dividends and peak-to-peak earnings on the S&P 500 are remarkably well-behaved and predictable within a narrow range. Using a 6% assumed long-term growth rate of dividends (matching the peak-to-peak historical growth rate of S&P 500 earnings), the index level currently required to deliver a 10% long-term total return to investors would be 652 (the S&P 500 currently trades at 1251.54).
The actual growth rate for S&P 500 dividends since 1940 has averaged just 5.7% annually. Using that growth rate, the implied value of the S&P 500 is just 607. Using more optimistic assumptions, the fastest 25-year growth rate for S&P 500 dividends over the past century has been 6.7% annually. If we assume that growth rate for future dividends, the implied value of the S&P 500 would presently be about 788. Though the higher range of that 607-652-788 area seems about right to me, given other information such as earnings, profitability, and so forth, all of these figures are plausible regions of “fair value” on the assumption of 10% long-term equity returns.
Looked at from another perspective, the data fits our belief that the market is currently in a P/E contraction cycle. The last such cycle lasted from the late 1960’s until 1982. Although there were certainly both bull and bear markets during those years, the overall trend was sideways, as can clearly be seen in the chart. So, rather than immediately falling below 800, it would be just as likely that the market trades sideways for a few years, until (like in the late 1970’s) it has actually traded below the trendline for a while. After all, it can’t be an average if all of the points lie on or above the line.
More realistically still, we will probably see both drops to 800 and gains to 1,200 in an overall range around 1,000 until finally the valuations bottom out and another expansion wave can begin.