Below is a compilation of a few of “Davidson’s” emails from the last few days in response to questions on the S&p 500 intrinsic Value
SP500 Earnings are not calculated by formula, but measured since 1940 and then extrapolated forward. The US quarterly annual RGDP growth rate is plotted from 1930 and a regression is run using full cycle data. The underperforming RGDP data from 2008 onward has been excluded. The earnings trend is then divided by the RGDP+12mo Trimmed PCE to give the SP500 Intrinsic Value Index.
The data is plotted as below. The trend channel is drawn and then the mid-trend is found by trial and error. The historical rate of earnings growth is 6.1% +/- 38.7%.
The US is the most Free Market and the earnings growth has held up over time remarkably consistently. Our Real GDP is ~3% and very slowly declining from a 1930 level of ~3.9%. Again very remarkable considering our GDP was ~100Billion in 1940 vs. ~17Tril today. Considering law of large numbers one would expect a more rapid decline of returns with a 1700x increase in size. Socialistic countries like France have a Real GDP growth of ~2%.
Today’s 12mo Trimmed Mean PCE from the Dallas Fed is 1.6% so that the divisor (earnings cap rate) is now 4.6%
If the US imposes rules sufficient to slow our historical growth, then our RGDP will trend towards lower performing economies. It will be difficult to see this over the short term, i.e. less than 10yrs.
I make the assumption that since we have continued our growth rate with many political changes or attempts at change that as long as we protect private property rights we should continue the historical trend. If one reads history, one will slowly develop a strong confidence that private property rights instill a confidence that recovery to former growth trends are the most likely outcome to economic corrections.
Looking at market valuations is not a mathematical process. It is recognizing that what one is looking at is aggregate human behavior under a set of societal rules which balance individual and gross social norms. Finding a trend in the information has been for centuries like looking for a needle in a haystack. The US has been the best measured society with the data most readily available.
The more productive assets are placed in the control of free markets with minimal but effective rules to ensure fairness in transactions, the higher the overall RGDP. One cannot predict what RGDP should be based on an assessment of the rule set. One can only see what RGDP has done historically in a particular economy, measure how the markets have priced assets and make estimates going forward.
In economic/social systems change occurs slowly. Typically more than one business cycle is required to assess the impact on pricing. This forces one to view pricing as dependent on investor behavior. What comes out of this is that Value Investors do in fact act with the SP500 Intrinsic Value Index in mind and are responsible for major market lows in recessions. But, market tops are due to speculators playing economic headlines and since 1995 this has meant Momentum Trading Hedge Funds.
I use a spreadsheet formula only to simulate what I see in the data behaviorally. The market is at all times a mix of perceptions
SP500 Intrinsic Value SPDR S&P 500 ETF Trust (NYSEARCA:SPY) vs. actual SP500 price is very market psychology dependent. The intrinsic value is the long term earnings trend divided by the long term GDP growth rate. It is a fundamental valuation measure and coincides with the buying of Buffett and other successful Value Investors. They are asset buyers and have a long term view of what earnings those assets can produce in a recovered economy vs. what general economic growth rate. This is how market bottoms are formed during recessions.
Major market highs are an entirely different story. These are pure market psychology supported by economic headlines and the belief that if one has a positive surprise, then a higher market is justified. In fact exact cycle highs and lows are both created by surprise economic headlines with most investors reacting to the unexpected. But, at the lows, buying by Value Investors brings in ‘buying pressure’ which convinces Momentum Investor to follow suit.
There is a great belief in ‘Efficient Markets’ or ‘The Invisible Hand’ which cause most investors to become trend followers even if they describe themselves differently. This makes understanding what those who seems to be successful are actually doing. David Tepper who claims to be a Value Investor just went from Bull to Bear and back to Bull again in the past 3mos. He reveals himself to be a trader but does not describe himself that way.
To be a Value Investor one needs to be able to not only understand how value is created in businesses, but how other investors interpret perceived changes in value into market prices. This is what I do!! Having the SP500 Intrinsic Value Index lets me know where the value is. Any difference between the SP500 Intrinsic Value vs. actual SP500 price is market psychology. With this perspective I can see what is driving market pricing and this helps me to combine both value and broad changes in market psychology to maximize my returns. Knowing that SP500 can soar to 100% of the SP500 Intrinsic Value Index due to economic news, permits me to see that when the T-Bill-10yr Treas credit spread moves to zero markets peak, home sales and vehicle sales peak and I should exit the equity market place.
So…I use SP500 Intrinsic Value Index to buy lows and credit spreads to sell the highs. This approach recognizes that pricing is never precise as it is at all times driven by market psychology. This approach lets me take advantage of the major swings in market psychology and stay the course during economic expansion to maximize the price change in the markets.