Sunday, May 5, 2013

Valuation (excerpt)

The forward P/E of the S&P 500 rose to 14.0 on Friday, the highest since April 2010. Over the past seven weeks, the forward earnings of the S&P 500 has leveled out around a record high of $115 per share. Now that the index is already within sight of my yearend Rational Exuberance target of 1665, what is the upside in an Irrational Exuberance melt-up scenario? Let’s review the potential upside suggested by some valuation models:

(1) Fed’s Stock Valuation Model. In 1997, I noticed that the second section of the Fed’s Monetary Policy Report to Congress included a chart and a brief discussion of the close fit between the 10-year Treasury bond yield and the inverse of the S&P 500’s forward P/E. I dubbed it the "Fed’s Stock Valuation Model" (FSVM). The model became instantly popular and controversial, as discussed in a Wikipedia article about it.

Ironically, after I “discovered” the FSVM, the Fed never mentioned it again, and it hasn’t even worked for the past two decades. It was bullish on stocks during the bull markets of the previous and current decades. But they were driven mostly by rising earnings, while the secular trend in the valuation multiple was downwards. The FSVM currently suggests that stocks are 75% undervalued relative to bonds. Alternatively, bonds are grossly overvalued relative to stocks.

(2) Rules of 20. A simple alternative to the FSVM is the Rule of 20, which compares the forward P/E of the S&P 500 to the difference between 20 and the CPI inflation rate on a y/y basis. Currently, it shows that the P/E should be 18.5, well above the market’s current P/E of 14. That would put the S&P 500 at 2133, or 32% above Friday’s close.

A hybrid valuation multiple that combines the Rule of 20, the FSVM, and our Blue Angels multiplies the latest forward earnings of the S&P 500 by the P/E derived by subtracting the 10-year Treasury bond yield from 20. The result shows that the S&P 500 should be around 2100.

Today's Morning Briefing: Rules of 20. (1) The valuation question in London. (2) From downside to upside. (3) Ahead of schedule on yearend target. (4) Qualitative and quantitative dimensions of a melt-up scenario. (5) One more time: Don’t fight the central banks. (6) Phasing out phasing out QE. (7) Draghi “ready to act if needed.” (8) Japan may be a leading indicator. (9) Playing both defense and offense. (10) Valuation models for a melt-up scenario. (11) Payrolls rose, but paychecks fell in April. (12) Focus on market-weight-rated auto-related stocks. (More for subscribers.)

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