S&P 500 Intrinsic Value Rises to 2003 by ToddSullivan, ValuePlays

“Davidson” submits:

We are at that point in the economy and market prices where there are still many positives yet to unfold but with a substantial number of investors who would like to participate in equity returns still gun-shy of the correction of 2008-2009. What occurs at this point is the invocation “The Invisible Hand”/ “Efficient Market Theory” concepts(I see these as identical perceptions). As the economy continues to improve, capital gradually leaves the safety of fixed Income for equities. We begin to justify our decisions to switch asset classes by saying that the markets are driven by forces we do not understand but believe to be rational. The equity market jumps on every little piece of better news than we expected. We come to believe more strongly in the market as an entity which has a knowledge unknown to us, in fact better than us in correctly pricing stock prices even though we do not understand it. The entire market becomes a ponzi scheme of belief driven by investors who think it is “The Invisible Hand” when it is actually themselves turning a little more bullish every day. Soros called this “Reflexivity” but many before him have seen this phenomena and called it what it is, i.e. mania.

The investor effect is to drive the markets higher by selling fixed income till the economy peaks and the good economic news stops flowing. The economy is in fact driven as far as individual capacity for borrowing and spending allows and it slows down naturally as short term rates rise and bring bank lending spreads to zero. Bank lending comes to a halt! One sees this in our historical record going back as far as we have data. It is my current estimate based on the $3tril now in Hedge Funds and the bias for using computer driven models that this cycle’s peak economic/market activity may occur 5yr-7yr from now. There is no way one can be precise in this estimate as we are dealing with is market psychology. But, we can monitor the economy and one will be able to determine when we are close to running out of lending/spending power.

My guess as to how high the market could go is over 2X current levels for the S&P 500. But, this I must emphasize is only a guess, based on our recent market peaks. Market prices are based on what investors as a whole believe things are worth. At the moment investors favor Tesla Motors Inc (NASDAQ:TSLA) over Ford Motor Company (NYSE:F) with Ford by far offering better investment value. But, such is market psychology that Ford could easily not provide investor returns as long as Tesla maintains investor confidence. Investors could easily not make the transition from fixed income to equities I anticipate and the S&P 500 (INDEXSP:.INX) could remain flat even with substantial economic growth going forward, such is market psychology. But, history tells us that the odds that investors would act contrary to how they have acted in the past seem quite low. I simply do not anticipate investors acting any differently than they have in the past, period!!

Whatever transpires, I think we are justified in expecting the S&P 500 (INDEXSP:.INX) to rise till the economy peaks. When the economy peaks, I expect the S&P 500 to peak shortly thereafter. For now I continue to recommend a strong bias in favor of equities and an equally strong bias against fixed income.

The July 2014 12mo Trimmed Mean PCE was reported at 1.6% or 0.1% less than the 1.7% reported the previous  month. Inflation remains relatively calm. The impact to the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) Intrinsic Value Index is to cause it to rise as inflation falls to $1,964-as shown in the chart below. The S&P 500 at $2,003 remains fairly close to fair value but still showing the signs of entering a Momentum Market dominated by Momentum Traders in my analysis.

S&P 500

Historical analysis indicates that Momentum dominates markets in the latter half of the economic cycle. I estimate at this time that we still have 5yrs-7yrs left to go in this economic cycle. Higher stock prices in spite of any negative news is not unexpected even though for the most part higher prices are a surprise to many market pundits. Higher markets should continue till economic activity peaks.