Understanding the stock market

19 July 2013

This extraordinary stock market is driven by characteristics that defy conventional valuation techniques. I receive emails from people who tell me that the market is overextended, overvalued, and trading way above its 50- or 200-day moving average. If you look at the metrics, the market is all of those things.

I receive other emails that talk about the valuation of the market. Is it reasonably “fair?” If you look at earnings expectations and the price of stocks this year and compare them to a metric, you would say the market is reasonably priced.

The math goes something like this. The S&P 500 Index will earn an estimated US$105-US$110 for 2013. That puts it at a multiple of about 15 times earnings. Those earnings are being reported by companies that have minimal distortions due to inflation or accounting mechanisms. Thus the earnings are of a higher quality in terms of reporting than they have been in the past. They do not reflect the bubble of the 2006 and 2007 financials. And they are more representative of the diversity of American companies. Our metric would say the market is reasonably priced. Not a great market, but certainly not excessive.

The next metric ties the relationship between stocks and interest rates. We use a number of vehicles to make this comparison. I like the calculation of the equity risk premium that says how much you get paid for owning stocks versus riskless debt instruments. If you compute an equity risk premium against an interest rate next to zero, the valuation of stocks could be infinite. Anything compared to near-zero has a huge bulge in its multiplier.

If you compare stock valuations against the 10-year riskless Treasury note, the equity risk premium is still very high by any historical measure. Why? Because the Treasury interest rate is so low.

If you try to compare the equity risk premium against what you believe to be the normalized 10-year Treasury interest rate, you still get a fairly reasonable equity risk premium

The math is straightforward. Take the earnings and the earnings yield of the S&P at about 7 per cent. Normalize the yield on interest rates that you expect to occur 2-5 years from now. Let’s say those rates are in a range of 3-4 per cent rather than the current range of 0-2 per cent. Using this new math, you would achieve an equity risk premium 4-5 years from now of approximately 3-4 per cent. Thus you would conclude that stocks will then be reasonably priced.

Next metric.

What will the earnings be for the S&P if you use this equity risk premium metric that we just described? Answer: somewhere around US$135-US$140, maybe US$150, depending on the robustness of the economy. In which case, these stocks are currently cheap.

Let’s sum this up. We are going to have very low interest rates for the next couple of years, maybe longer. We are going to see gradual recovery, maybe more robust over time, but certainly not a screaming rebound. Under those circumstances, the likelihood is that stocks will go higher, maybe much higher.

Our targets for US stocks at the end of this decade are about US$2,200 on the low end of the S&P 500 Index to about US$2,500 on the high end. Those stocks will be earning US$140-US$150 annually, in an environment of low interest rates and inflation. Note: interest rates do not have to be near zero; they could be 3-4 per cent. The mortgage interest rate in the US might increase by 100 or 150 basis points. If the unemployment rate and overall employment situation in the US have healed to some extent by decade's end, then all of these numbers are perfectly reasonable.

We do not know what the stock market is going to do. Nobody does. We do not know whether the world is going to come to an end, or is going to be chugging full steam ahead for the next 15 years. Nobody does. What we do know is that when you line up all of the metrics that you can use to value stock markets, most of them will tell you that stocks are fairly priced and strategically cheap if you have a longer-term view.

Source: btinvest

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