Stock Market Fair Value – What S&P 500 Should Be (Beginning of December 2013)
At the beginning of each month, I will talk to you about something called stock market fair value. It’s not something I want you to use to make immediate changes in your investment portfolio. Very rarely does anyone or any system provide you instant wealth like that, so be very skeptical if anyone makes such claims.
NOTE: You may be reading an outdated analysis. Please visit my latest Stock Market Fair Value article.
Stock market fair value relies on a concept called “market valuation” and refers to the process of figuring out what the stock market should be worth. By that, I mean what the level of the S&P 500 should be. That is a broad measure of the value of the stocks of the 500 largest companies. If there’s anything that is constant in the markets, it’s that there will be ups and downs. But over the long run, there are some things that generally hold true. For more details on the information I present in this post, go to Easy Intro to Stock Market Fair Value. You could also just read this post for the bottom line on whether the stock market right now is “cheap” or “expensive” relative to a fair price. Keep in mind that these deviations from a market fair value price can last a long, long time (months or years), so don’t go and tweak your portfolio every month based on this information. Instead, use it to adjust your long-term expectations for the purpose of financial planning.
The four methods of determining stock market fair value below all come from Doug Short’s fantastic blog that is on my daily “must read” list.
First, here are two methods employing the use of “price to earnings ratio” …
Basic methodology: Investors like profits, and they are willing to pay a certain amount of money for a certain amount of profits. That ratio has a fairly constant long-term average, so we can tell how far above or below that average we are. Thus, we can estimate whether the value of the S&P 500 is currently too high (“expensive”), just right (“fair”) or too low (“cheap”).
What It’s Telling Us Right Now: According to this method, at the end of November 2013, the S&P 500 was 79% higher than it should be (versus 73% higher one month ago) based on historical average price-to-earnings ratios. This is a significant deviation from normal, suggesting that stocks are generally too “expensive” right now.
Cyclical P/E 10 Ratio
Basic methodology: This is similar to the Crestmont method above with a couple of exceptions. The two methods have different ways of calculating the earnings (“E”) component of the P/E Ratio. Also, if you do a best-fit (“regression”) line through the value of P/E 10 ratio over time, it’s sloped upwards, which means that over time, the average P/E 10 ratio has been rising. As of the end of December 2012, I’m going to look at how much higher/lower the P/E 10 ratio is versus the regression line, not just the historical average of P/E 10. It makes the market less “expensive” to do this, but I also feel there may be something to the notion that things have changed over time and want to account for that here.
What It’s Telling Us Right Now: According to this method, at the end of November 2013, the S&P 500 is 31% higher than it should be (versus 26% higher one month ago) based on historical price-to-earnings ratios (actually a best-fit line showing where that average should be today). This is a deviation from normal, suggesting that stocks are generally too “expensive” right now. In fact, according to GuruFocus, based on the P/E 10 ratio as of the time of this posting, the S&P will rise at an annual rate of only 1.1 percent for the next several years (probably about 10 years, though the site doesn’t specify) – very anemic growth.
And now, the last two methods for determining stock market fair value: continue reading…