The issue of the chartist(containing this info) has been in public libraries for a few months, so I guess it is OK to post it now.
QUESTIONS & ANSWERS
QUESTION: Is the market overvalued
or undervalued? With the S&P 500 PE ratio at
27 compared to the long-term average of 15,
many pundits claim the market is still way over-valued.
To meet the historical average of 15, the
S&P would need to fall another 45%. What is
your opinion?
ANSWER: Stocks must compete with
other investments. Using an average PE is
meaningless. The Greenspan model compares
the earnings yield of the S&P 500 with the 10-
year treasury yield to estimate fair value. The
earnings part of the equation is based upon the
12 months ahead operating earning estimates
produced by I/B/E/S of $55 per share and the
10-year Treasury Bond yield of 4.71%. The fair
value calculates to be $1175. By this measure,
the market is about 13% underpriced.
Of course, the forward earnings of $55 is
very questionable in light of current conditions.
What if the forecast was 20% below the current
forecast? In that case, the market is overpriced
by 4%. If the current forecast is off by 30%,
then fair value of the S&P 500 is 800 or about
25% overpriced.
....................................................
The Chartist model uses reported 12-
month trailing earnings for the S&P 500
($36.85) which produces an earnings yield of
3.66%. We then compare it with the current T-billl
yield of 2.33%. With the S&P yielding
about 57% more than T-bills, our model is
showing an undervalued S&P 500.
.......................................
Let's take 1982 as an example. With
inflation out of control, Paul Volcker, the
Federal Reserve Board Chairman, had racheted
up interest rates to record levels; from mid-1981
into 1982, T-bills reached 16.75%, Fed funds -19%,
and the discount rate 14%. As late as July
15, 1982, T-bills were 12.81% and Fed Funds
were 14.47%. With Latin America on the edge
of collapse and the U.S. not far behind, the Fed
decided inflation was dead, and it was time to
reflate, and started aggressively to lower rates.
At the market bottom on 8/12/82, the PE
of the S&P 500 was a measly 6.9. The earnings
yield of the S&P was 14.47%. The earnings
yield of T-bills was 9.66%. Interestingly, the
S&P was yielding 50% more than T-bills -
about where we are today. Our model in 1982
indicated an undervalued S&P 500 just like
today.
In contrast, on April 3, 2000, with the
S&P at 1506, the S&P yield was one-half of the
T-bill yield, the lowest ratio in our database
going back to January, 1942 - and, we might
add, the most overvalued in history.
...........................................
The point is that using an average PE
ratio by itself is very misleading. When the PE
(more precisely, its reciprocal or yield) is compared
with competing investments, the picture
tells a different story. Our model and the
Greenspan model, while not market timing
tools, give a better representation of relative
value than the PE used in isolation.
The bottom line is we are probably closer
to a bottom rather than on the verge of another
major sell-off, based on market valuation relative
to competing fixed income investments.
...........................................
"the Chartist" is rated best over the last 20 years by
Hulbert Digest. The Chartist is the only newsletter that
has "actual brokerage" record of his trades
...........................................
Hope this helps
Larry Dudash
www.thechartist.com |
