The stock market was up huge today, posting one of its largest one-day increases ever. Finally! After four weeks of never-ending declines, the stock market rallied with jubilance. And with a stroke of luck, last week I went 50% into stocks from being 100% in cash. I did, I think, what is required of me: I protected capital on the downside, and at levels I was finally comfortable with, I put some money to work. This time it paid off. But believe me, there are other times when it doesn’t – swing and a miss.
A rally like today begs questions. Were stocks too undervalued that finally some market participants thought it was a good time to grab some shares? Or are stocks still overvalued and that this mini-rally may prove short-lived? Is there a happy medium? What changed?
Today’s extravaganza was sparked by Citigroup’s surprise announcement that the company is thus far profitable this quarter. In addition, Federal Reserve Chairman Ben Bernake gave a rare pre-market speech. Even more surprisingly, he actually had something significant to say. He mentioned that some accounting standards might need to be reviewed, a general statement that was interpreted by the stock market as a referral to FAS 157, Mark-to-Market. Later in the day, Representative Barney Frank, Chairman of the House Financial Services Committee, projected that the up-tick rule would be reinstated within a month by the SEC, thereby making stocks a tad more difficult to short. Certainly there might have been other factors that didn’t catch the big headlines which moved the market. Plus, the rally itself could have been self-reinforcing: the market being up big possibly drives others to buy into that rally, adding fuel to the fire.
What needs to be understood is that stock markets are (1) forward-looking, and adjust to expectations, particularly future earnings; and (2) can be irrational, that is, that stocks can rise or fall too quickly or too much based on human emotion. The stock market, as all markets, is inefficient and thus can become distressed in times of great uncertainty and fear, or, as former Federal Chairman Alan Greenspan once said, irrationally exuberant when optimism of the future goes too far and greed takes control. Today was merely a vote of confidence that can change swiftly or sustain itself. The simple fact is that no one knows with any degree of confidence. It took me 18 years to finally realize that.
Yet every professional investor tries to assess current market conditions based on their school of thought, accessibility to information, valuation models, chart patterns and confidence. I have my key model, among others, that I will share with you.
My model is called the earnings capitalization model (ECM). It is based on forward earnings and growth estimates, summed up, and discounted back to the present day. It’s derived from a well-known dividend discount model; with years of tweaking I can claim it as my own. It isn’t perfect, but it’s useful when current S&P 500 Index levels greatly differ from the model’s estimates. The ECM:
The model is a matrix, a range of values, given certain levels of key variables. On the left-hand side are the aggregate earnings estimates of all the stocks in the S&P 500 Index for the next year. On top is a range of interest rates of the US Treasury’s prevailing 10-year note. The bottom left-hand box is most important. It compares the current S&P 500 level to what the model computes as fair value. The bottom-right hand box posts the price-to-earnings ratios (P/E) at those levels implied in the left box.
According to the ECM, the S&P 500 might be fairly valued at roughly 1,000 given earnings estimates and the yield in the 10-year US Treasury Note, which themselves, are subject to change. Over the next twelve months, the S&P 500 could see 1,090. Be mindful that the variables that help compute S&P 500 levels change daily, and thus the model’s projections change.
The ECM has other variables that go into its computation that are too complex to describe in a blog post. But above, you see the main ingredients. For those interested, email me and I’ll share the other factors with you.
My model implies that stocks are undervalued, in general, represented by the S&P 500. Fair value is judged to be 1,000, a 40% level above today’s 714. Over a year, it implies that we could see 1,090, a 52% rocket. Is this realistic? Probably not. The model, like ALL models, is imperfect. But its direction is important, and it suggests that stocks are currently undervalued, and a good bet over the long-run.
Keep pressing,
Chris Monoki
[...] on my valuation model, I posted that stocks, as measured by the S&P 500, were fairly valued at 1004. The model only discounts earnings expectations and dividend payouts relative to the 10-year U.S. [...]
[...] a past post, I was hoping for the S&P 500 reaching 900. It just might do that. And I still see fair value on the S&P 500 around 1000. But this week’s market action has the ‘feeling’ of topiness. In other words, every [...]