Today marks the close of one of the wildest weeks we've seen in the U.S. stock markets in a long time. At DCM, we have developed several valuation models that help us gauge where the fair value of the major indices are at any given time. These models help us separate the emotional roller coaster of the stock market against the reality of what the fundamentals are telling us.
We know these models are never going to be 100% accurate, but they have been particularly good over the long-term. We have used them for many years to help us navigate uncertain times. With the markets getting choppy this week, we thought it would be helpful to show you what those models are currently saying.
Model #1: Long-Term Divearn Model (going back to 1962)
This model uses dividends amongst a couple other variables to predict the fair value of the S&P 500 index. This model has predicted roughly 91% of the movement of stock prices going back to 1962. For brevity's sake, we've shown only the years from 1990 through 2016 in the chart below.
The grey bars represent DCM's predicted fair value. The "blue shadow" represents the model's error range. And the red line is the S&P 500's actual price.
As you can see, the red line (price) always tends to move towards fundamental value (grey bars). In most years, the S&P 500's price stayed within our model's fair value range (blue shadow).
Over the years, this model has been very effective. The market was grossly undervalued in the early 1990s before becoming grossly overvalued in the late 1990s. In 2002, the market came right back down to fair value. The financial crisis of 2008-09 again presented a great value. Since then, the market has moved up towards fair value and stayed right with our predicted fair value.
At this moment, the model is predicting the current fair value of the S&P 500 is 2,148 (+8% from here). There is an error on either side of that number. The market's low this past week was 1,867 - just modestly below the lower range of our model's estimates.
Model #2: Forward Divearn Model (going back to 2009)
The second model uses the same inputs as the first, but with two differences: (1) It uses forward earnings/dividends and (2) it uses the most recent 6 years (2009-2015). It has predicted roughly 93% of the movement of stock prices going back to 2009.
Again, you can see that the price (red line) follows closely to the fundamental value (blue bars). The market got outside of the error range (blue shadow) in just 5 out of 23 quarters.
You will note that the market got too high in the 1st quarter of 2015. Since that brief overshoot, we've seen stock prices go flat and now down. The primary culprit was the decrease in the energy sector's forward earnings. Once those were past us, we've started to see fundamental value increase as we move towards the end of 2015.
You'll notice that the S&P 500's price has reached the lower end of the model's range. This would suggest that stocks are trading at a discount to their current fundamental value. According to this short-term model, the fair value of the S&P 500 over the next 12 months is 2,153 - a roughly 9% discount from the market's price as of today (Friday).
What Does It Mean For You?
Both of our models are saying the same thing. As long as there is not a recession on the horizon, these models give us confidence that stocks present a good buying opportunity at this point. As we talked about in a previous blog post, the "dog" (stock prices) can't get too far away from their "master" (dividends) over a long period of time.
While this market volatility can shake your confidence, it presents an opportunity for the long-term investor. Looking at the fundamentals (dividends and earnings), it appears that we are trading lower than we should be.