Stock Market Fair Value – What S&P 500 Should Be (Beginning of February 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NOTE: You may be reading an outdated analysis.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” …
Crestmont Research P/E Ratio (from Crestmont Research)
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 January 2013, the S&P 500 was 55% higher than it should be (versus 47% 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.
What It’s Telling Us Right Now: According to this method, at the end of January 2013, the S&P 500 is 34% higher than it should be (NOTE: I accidentally forgot to use the regression line as comparison like I did last month, so this looks like a big jump from last month – and I don’t have access to historical numbers from Doug Short, so no comparable value for last month to compare to) based on historical price-to-earnings ratios. 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 annual rate of only 2.3 percent for the next several years – very anemic growth.
And now, the last two methods for determining stock market fair value:
Basic methodology: It looks at the ratio between the current price of the market and how much it would cost to replace all of the assets owned by all the companies in the S&P 500. It gets too difficult to explain just how they do this, so just accept it and see what the results say. If you must know, go to Hardnomics.com (just kidding, I hope there’s no such site!)
What It’s Telling Us Right Now: According to this method, at the end of January 2013, the S&P 500 is 39% higher than it should be (versus 34% higher one month ago) based on historical average. This is a significant deviation from normal, suggesting that stocks are generally too “expensive” right now.
Comparison to Trend
Basic methodology: Looks at the price of the S&P 500 on a chart from the beginning (around 1870) through today. A “best fit” straight line (called “regression trendline”) is drawn to cut through all the price points. That represents where the S&P 500 “should” be to represent a market fair value level.
What It’s Telling Us Right Now: According to this method, at the end of January 2013, the S&P 500 is 52% higher than it should be (versus 48% higher one month ago) based on its long-term trend. This is a significant deviation from normal, suggesting that stocks are generally too “expensive” right now.
Four reputable and well-accepted methods used to determine a fair price for the S&P 500 all suggest that it is currently too expensive, by anywhere from 34-55 percent. One month ago, this was 34-48 percent too high, which means the price of the S&P 500 (as measured by the midpoint of the range) became more expensive by about 3.5 percent. That decreases long-term expectations of market returns from an already low level, nowhere near the historical average of around 8 percent.
Does the current overvalued price of the S&P 500 mean people should rush out and sell their stock holdings? No. Of course, it’s hard to blame anyone for doing that in light of all the problems being discussed worldwide. But strictly from this data, no. What this does mean is that the long-term expected return of investing in the S&P 500 is likely to be lower than average. You know how some people say that stocks go up about 8-10% per year as a rule of thumb? Well, that thumb is much shorter in the next 10-20 years basically. Use this information in formulating your long-term plans, not your short-term ones.