The inflation indicator from Dallas Fed (Trimmed mean PCE) reported at 1.8% for past 12mos. Inflation coupled with the historical Real GDP trend create the “Prevailing Rate” which is used to capitalize the market’s return and provide a price estimate for the SP500. The current Prevailing Rate calculates to 4.89%
How this works across the business cycle is to take the long term earnings trend for the SP500 and capitalize the current monthly earnings trend value by dividing it by the Prevailing Rate:
The capitalization calculation gives a Dec 2011 estimate for the SP500 of 1507.1 while the closing price for Dec 2011 was 1257.6-see the chart SP500 vs. SP500 Earnings Trend Index below. To place this analysis in the proper perspective, an SP500 level of 1507.1 today represents the historical level of support investors have given the SP500 since 1978 (inception date of Trimmed mean PCE). I interpret this level as the buy point for long term value investors. The historical literature indicates that value investors buy stocks based on long term earnings trends and expectations that the trend is likely to recover.
Today using this analysis the SP500 is ~20% undervalued. But, an SP500 at 1507.1 is not what I am expecting for this market!!
If the business cycle lasts another 5yrs and inflation remains at the current level, then the SP500 would have a valuation of ~2025 in 2017. But, the potential exists for momentum hedge funds to price SP500 rising on the good news from a fully involved economic expansion as much as 50%-100% overvalued. I fully expect that we will witness an overvalued market at the point of economic maturity and have a strategy to deal with this when the time arrives which I have described in previous posts.
I have been recommending that investors be positive on equities since early 2009-see the “Bullish Recommendation Period” in the chart above. The current SP500 remains ~20% below the historical support level. The pull back on the European debt concern this summer will be seen in my estimation as a short term event and similar to the Iraq War of 2003, the Internet Bubble of 2000 or the Real Estate Collapse of 1990 – it will pass and the SP500 should track the economic trend as it has historically.
Already the market is becoming increasingly more comfortable with the financials and real estate while auto sales, global trade, industrial production and retail sales continue strong trends. The employment trend appears to be accelerating. Growth is all about employing individuals in productive activity who in turn add demand to the system which employs yet more individuals. There is a limit to this, but at the moment we are still in the early stages and have several years ahead of an increasingly more vibrant economy based on historical trends.
Inflation is relatively contained, the SP500 appears quite undervalued and the future looks bright. Optimism is warranted!!