S&P 500 Intrinsic Value Update by ToddSullivan, Value Plays
The Dallas reports 12mo Trimmed Mean (inflation) at 1.7%. This is flat with last month’s level but 0.4% higher than the trend in place for 1Q14 and most of 2013. Higher inflation lowers the value of the SP500 Intrinsic Value Index which tracks that level at which Value Investors find stocks generally attractive. The S&P 500 rising above the S&P 500 Intrinsic Value Index is characteristic of Momentum Investors becoming more dominant in market pricing. Today the S&P 500 (INDEXSP:.INX) sits at ~$1,930 vs. SPDR S&P 500 ETF Trust (NYSEARCA:SPY) Intrinsic Value Index of $1,824.
Market pricing in my opinion is mostly controlled by Value Investors at recession lows but controlled mostly by Momentum Investors at market highs. During the economic cycle Momentum Investors who typically respond to price patterns and economic reports gradually come to dominate pricing and drive markets well above levels at which Value Investors find attractive. The S&P 500 2000 & 2007 market peaks were 100% & 55% above their respective S&P 500 Intrinsic Value Index levels. With Hedge Funds now holding $3tril I expect we are likely to see a similar period of excess pricing during the current market/economc cycle. I expect the current cycle to last another 5yrs-7yrs as housing and commercial construction recover to historical trends.
Momentum Investor domination of market pricing is a recent phenomena. It began with the evolution of Hedge Funds which at $100bil in 1995 began to dominate market peak pricing with their algorithms. Prior to 1995 market pricing tracked the S&P 500 Intrinsic Value Index as shown in the chart below.
Security pricing in my view is at all times through the perceptions of investors contemplating current news, especially earnings which are then coupled to future economic expectations. In short contrary to the majority view, market prices are dominated by market psychology. Since human psychology cannot be accurately quantified, it cannot be used in mathematical formulas and cannot be used to predict outcomes of future market pricing with any degree of certainty. Yet, we claim to do this all the time and we teach that we can do this in all our universities. No wonder so many receive less than market returns.
As investors, we need to incorporate both Value and Momentum thinking in their investment decisions. Otherwise, we will miss substantial opportunities and incur excess risks. Even though the S&P 500 is above the level considered generally attractive by Value Investors, Momentum Investors have not entered the market in force. As the economy continues to expand, we should witness a strong shift in Momentum Investor psychology towards the positive end of the spectrum. This should continue till the economy peaks. As this occurs, equity prices should continue to rise well above the S&P 500 Intrinsic Value Index. We very likely will see market prices at levels similar to 2000 & 2007. Once one can visualize equity prices through both Value and Momentum perspectives, one becomes a more complete investor and can take advantage of opportunities across the entire economic/investment cycle.