WHAT IS THE S&P 500'S FAIR VALUE?
Macro, Value, Medium-Term Horizon
Seeking Alpha Analyst Since 2020
Ex-hedge fund analyst at $40bn fund. Currently managing my personal investments across asset classes using a medium-term macro framework. Building a platform to help others do the same.
Summary
- Current market sentiment is too positive.
- Federal Reserve easy monetary policy will continue to support stocks.
- We see small single-digit gains for the S&P 500 over the next year, with risk to the downside.
I’m using the following identity to project the S&P 500’s fair value on a ~1 year time horizon:
S&P 500 Fair Value = P/E Ratio*2021 Earnings
P/E Ratio = 1 / (US10yr treasury yield + Equity Risk Premium)
The model uses 3 key assumptions:
- Earnings growth (relative to 2019)
- The US 10year treasury’s yield
- The equity risk premium (market sentiment)
Earnings Growth
- S&P 500 annual earnings growth averaged about +7% from 2012-2019, ranging from around -15% to +20%
- 2019 was +6%
- The incoming administration is likely to push for corporate tax increases, but the Republicans are currently favored to maintain control of the senate. If Republicans hold the senate, corporate tax hikes are unlikely to become law in the near term.
- Continued large fiscal stimulus also becomes less likely if Republicans hold the senate.
- Given current COVID case counts nationally, a return to “normal” life is unlikely until there is broad distribution of a COVID vaccine. The current base case for broad distribution of a vaccine is ~May 2021.
-
Conclusion:
- Divided congress: no tax hike, small additional fiscal stimulus.
- Economic activity slows in winter as cases continue to rise.
- Assumption: -0.4% earnings y/y, but I think this is conservative and could be significantly lower.
US 10year Treasury Yield
- This assumption is difficult, but the key point is that the Federal Reserve has publicly committed to easy monetary policy until inflation is running above 2%.
- Core PCE (the Fed’s preferred inflation measure) was 1.41% in October 2020.
- Assumption: 0.9% (right around where it is now), but anywhere in the 0.6% - 1.2% range seems reasonable in the short-term.
Equity Risk Premium
- Current market sentiment appears giddy as indicated by both the CNN Fear & Greed Index, and a surge in retail investor interest over the past 9 months (as indicated by Robinhood brokerage activity).
- Fiscal stimulus, increased unemployment benefits, and government action such as the moratorium on residential evictions have helped the market ignore the dire economic reality that exists today. As these stopgap measures falter, that reality will become more clear.
- For example the unemployment rate is still >3% higher than where it was in February 2020.
- Assumption: 2.7%. This is tough to pinpoint, but it seems likely that this increases from the artificially low 1.85% it sits at today, with potential to go much higher if the market panics again.
S&P 500 Fair Value
- 1 year fair value = 3,859
- Trading 3,668 at time of writing, so the base case suggests ~5% of upside over the next year.
- I think there is more downside risk than upside risk to the fair value estimate, so I am not particularly excited about owning the S&P 500 in the near-term.
Analyst's Disclosure: I/we 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.