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S&P500, what's a fair level?

What’s a fair price for this index going forward?
 
In the past real GDP growth averaged 3.25%, with a trailing P/E on the S&P500 averaging 15.5X. 
 
The index closed the month at 19.9X trailing P/E (Shiller P/E is very high at 25). The thing is, it’s not the past anymore, we need to look at what’s on the horizon for the United States. Well, GDP growth has slowed with the average for the last 20 years being 2.4%. Today the US has used up every desperate stimulus trick in the book, and can barely hold 2%. 
 
Let’s be optimistic and say they can actually do 2% real into perpetuity. That means nominal is probably 4%, and corporate earnings grow by say 2%? Why would anyone pay 20X for that?
 
So what’s it really worth? I say S&P500 = 1387 is a fair value, which would be 14X. And that seems generous, only slightly below “the good old days”, which are long gone. Am I low, high, why?

Trailing P/E Shiller P/E GDP Growth Corp Profits

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I think the other aspect of the value equation that you should consider is the cost of capital. I agree with your math if you use historical costs of equity around 10-11%.  I think the 30-year historical average yield on the 10-year treasury is around 5.5% so you were basically requiring 2x that return for equities. Now the 10-year is hovering around 2% so people are requiring a lower return on their equity investments. The problem is that ZIRP has dropped this equity return down to somewhere around 8%. 

This comes back to the big question about long-term interest rates. If you think they will be low for a long time, 8% is probably a fair cost of equity capital for the market and the markets are probably fairly valued now. If you think interest rates will revert to their historical levels, 10-11% is a better number and the market is likely overvalued.

Ah, low cost of capital due to ZIRP, that’s a good point.

With cheap financing, if people don’t like their returns, they can lever up, which pushes up valuations further.

when i was in hs/college. i thought the stock market was about being smart and mathematical. As i started working, I realized that it is less quantitative and more qualitative and more about measuring confidence. when confidence is high, sell. when confidence is low buy. smart is good, but having the stomach and understanding history is far better. For example: you know in the last 100 years or so, the us market had about 50 market corrections (above 10% declines). 10% declines are really not that alarming and are fairly common granted we havent seen one since 2011. also on multiples, when inflation is low, typically multiples are high. when inflation is around 0% to 2%, multiples are roughly around 18x. when inflation is high, multiples drop hard, but important to note that earnings rise fast too, so prices can still go up or down.

Stimulative efforts such as printing cash or keeping rates low, is really nothing in larger scheme of things but symbolic. its important to note that the supply of money is mostly credit. In the US, About $3 trillion is cash vs about $60 trillion in credit. due to the housing bubble, the amount of credit loss was probably far more substantial than the amount of money printed.  so in summary confidence > credit. you can improve credit conditions by lowering rates and flushing everyone with cash, but like we saw in ‘08, if ppl are not confident, supply of money can still contract because of inability to borrow/lend.

another important thing to note is that the stock market is a leading indicator and economic indicators such as GDP is lagging. So when GDP prospects are weak, oil prices are low, it typically means the stock markets are proly going to rise. history runs in cycles, assuming low growth rates to perpetuity just cuz it is what is current is terribly faulty. investing is figuring out where we will be and not where we are. 

I love my cheese. I got to have my cheddar.

“10% declines are really not that alarming and are fairly common granted we havent seen one since 2011”

That was true until a couple of weeks ago. Not anymore!

research shows that economic growth is actually bad for equities over the long-run as it tends to come with high inflation. some growth is good but lots of growth is bad so the current environment is actually perfect for equities. and yes, corporate earnings can *almost* always be expected to grow faster than the general economy.

i see 18x trailing PE for the S&P 500 and a Shiller CAPE of 25x. if we assume a reversion to a Shiller CAPE of 20x (some historical premium is warranted due to the change in average business type and globalization) over a period of 10 years but no real change in traditional valuation, real organic corporate earnings growth of ~3% (roughly in line with historical) and an earnings yield of 5.55%, our 10-year expected return is about ~5% nominal. not the best but reasonable given the alternatives. if our traditional P/E drops to the long-run average of ~16x, which is unlikely if interest rates remain near zero, our expected return would be closer to ~3.8%. don’t count me on these numbers, they are basically back of the envelope.

Finally an S&P500 forecast out of Wall Street that I can get behind. Goldman says lame earnings growth and multiple contraction for years to come…

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And Kostin & co. don’t expect U.S. equities or the economy to kick into higher gear any time soon. As such, the strategists forecast that the years of double-digit returns for the S&P 500 have passed, calling for gains of 5 percent or less forecast out through 2018.

http://www.bloomberg.com/news/articles/2015-09-29/goldman-sachs-slashes-...

Now both Goldman and Blackrock admitting the party is over…

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“As the bull market approaches its seventh anniversary next March, investors are increasingly nervous. Partly, this anxiety stems from a deterioration in the fundamentals: The global economy has decelerated on the back of a slowdown in China and outright contractions in other large emerging markets. But years of unconventional monetary policy have also pushed valuations to heightened levels. The bull’s retort is that equity market valuations are justified given low rates.

The takeaway for investors is that while stocks are perfectly capable of turning in a stellar year or so, on a three- to five-year basis investors should expect significantly lower returns than they have become accustomed to over the past six years.”

https://www.blackrock.com/investing/insights/market-perspectives?cid=emc...

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The thing is, yes we can say valuations are high because cost of capital is low, but the fed seems to want to be able to raise rates while NOT having valuations come down. As if the math only works in one direction. I don’t see how they pull that off. Meanwhile a recession happens eventually, IMF tells us the global slowdown is here, and the fed has no tools to fight that.

My forecast for 2016 is the exact same as it was for 2015 – sideways market, struggling for barely up, but with gains lost multiple times during the year. We had four freak outs in 12 months where gains were lost (oct ebola, dec rates, jul greece2, aug china). I say these continue, and perhaps even increase in frequency and depth. Until the eventual pop!

Do you really trust that rubbish? Fear and greed son.

Fair value for S&P 500 is 200 points below purealpha’s short puts.  ;)

“I can no longer obey. I have tasted command, and I cannot give it up.”

CFAvsMBA wrote:

Do you really trust that rubbish?

Which part? Yes, my independent forecast agrees with those two’s forecast, but no it’s not based on “trust”. In 2007 Blackrock told me everything would be just fine in subprime, of course I didn’t trust that, as a lack of fear was not justified. In US equities fear, or reasonble expectations, seems justified.

^ So long as you’re doing your own homework.  I don’t put faith in 99% of stuff published as it’s either biased, general, or CYAesque.  

These market economists at big firms care about keeping their job first.  Then they care about generating business development.  Finally they may care about producing realistic forecasts.

Much like the weathermen on the news; they don’t give a fk about forecasting precise weather conditions, they care about keeping their job and selling commercial advertisement.  Is it any wonder weatherpeople are attractive men and women and not some nerdy overweight meteorologist?  

"You want a quote? Haven’t I written enough already???"

RIP

Remember that the economists at banks are hired because their brand of economics is palatable to bank management. They are not a representative sample of economic thought and thus their output is biased by what management wants them to say even if they themselves are executing their best efforts at analysis.

On top of that, many probably learn to soften their bad news and exaggerate their good news, even if only at the margins. 

You want a quote?  Haven’t I written enough already???

It’s not like this is some weird call guys, with earnings negative, multiples expanding but already streached, late-stage bull, and a global recession on the way – sideways but slightly up is a solid base case (even an optimistic base). Options also show people are preparing for the worst, so the market is not in disagreement.

High case is multiples expand further (no reasonable case for earnings increasing materially), maybe QE4 or NIPR. In other words all fake/manipulated upward movement.

Low case is a crash, or a depressing trickle downward. 

That seems reasonable, not sure how anyone could assign different probabilities, there’s nothing great to look forward to here…

Grantham has been saying this for a year or two now

^ Yeah this is nothing new. Dunno who Grantham is, but BChad and I called it in late 2014 “flat to slightly up in 2015 with gains lost multiple times during the year”, and we were dead right…I’m just extending that forecast into 2016. Nothing has changed, other than the global economic situation has worsened, and the bull market is one year older.

weve been in sideways markets since 2000 look it up

"You want a quote? Haven’t I written enough already???"

RIP

Have you ever been wrong on a call purealpha or do you bat 1.000?

“I can no longer obey. I have tasted command, and I cannot give it up.”

geo wrote:
Have you ever been wrong on a call purealpha or do you bat 1.000?

Well, as everyone can see by my posting history, I’m right a large majority of time, hehe sorry! cool
 
Investing is just probabilities; if the probabilities you assign to various outcomes are more accurate than what the market assigns, then you beat the market over time. Clearly the market assigns some really stupid probabilities sometimes, and that’s called mispricing, which is only clear to them in hindsight. That’s what I prey on, bias-driven mispricings.
 
That’s not to say that it can’t come up the only 15%-likely case, and you lose. The question in that situation is; was it just bad luck, or was it **** analysis and assignment of bad probabilities on your part? If it was the later then you identify your mistake (usually biases of your own) and learn, but you never score 100%, nor is that necessary.

Here’s something interesting, I took a deeper look at P/E history for the S&P500. 

First, we need to get the real P/E, free from American statistical manipulation. Obviously forward P/E is a joke, they crank this up, then when the quarter comes they crank it down, so they can “beat expectations”…so only trailing P/E can be used. Second, we have to use as reported P/E, not the operating P/E which includes “analyst adjustments”. If you look at the difference between the two, as reported is going up faster than operating, I’m going to go ahead and assume analyst manipulation here – between manipulated “operations” and “forecasts” they can make this look at 15X with a little magic dust. And then of course we have financial engineering to make P/E seem lower, but I don’t have any way of backing that out. So, what does that give us…
 
As reported P/E is currently 21.9X, but this is calculated before taking into account the negative earnings this quarter, it will be even higher once we close the earnings season. 
 
Looking back over the last 145 years, the average is 15.6X. Every time it approaches 23-25X it gets smashed down. Recent examples: Nov 2007 peaks 22.4X, Jun 1992 peaks 23.9X, Oct 1961 peaks 22.6X. The exception is Feb 2000 when it made it to 28.3X before the dobcom bubble burst!!
 
So it’s definitely very high right now vs history, but as Chad pointed out, there is no time in history where rates have been zero for this long, so we could make the argument that this is some sort of “new normal” given cost of capital. Still, I am skeptical – US GDP growth won’t be going anywhere, global growth forecasts decreasing, earnings are negative, financial engineering, central bank tricks are unsustainable, recession expected in next three years, yet multiple continues to expand?
 
Chart (remember you need to ignore post subprime and dotcom P/E distortions): http://www.multpl.com

Update: per S&P Senior Index Analyst, published Thursday close, the real P/E ratio is now 23.29X (earnings from real GAAP financial statements kids!). That’s with 88.5% of companies having reported earnings. Someone must have reported crap this week, because EPS crashed. The ratio has only been this high twice in the last 100 years, dotcom bubble, and 1992. Of course nobody in the finance sector will be mentioning this number…

Math = 2099.92 / $90.18 = 23.29.

Also an important fact from the same analyst: Q3,’15 buybacks continue, as the initial reports have Q3 33% higher than Q2,’15 and 6% higher than Q3,’14 

http://kr.spindices.com/documents/additional-material/sp-500-eps-est.xlsx

More importantly: Inflation won’t be going anywhere. As long as inflation rates in EMU/US are so low rates are going to stay low. I’d ratherexpect a significant shift in Monetary Policy paradigms than an increase in policy rates. (Like in Sweden). There was an interesting article about Yellen’s rule of the FED in ‘the Diplomat’ this weak which discusses this issue somewhat.

As the guy who checks people’s math, I would like to point out that Bloomberg are blatantly manipulating statistics, again.

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“On a share-weighted basis, S&P 500 profits were down 3.3 percent on year in the third quarter, marking a second consecutive quarter of negative earnings growth.” http://www.bloomberg.com/news/articles/2015-11-23/s-p-500-profits-fall-2...

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Wrong, Q3 earnings were down -14% YoY, marking a fourth consecutive quarter of negative earnings growth (per real math, which can be found in S&P’s excel download). Bloomberg share-weighted to get their number, which is NOT a proper method to use (explained by S&P here), and they did so in order to underrepresent the energy sector losses. Index earnings are simply the sum of the 500 earnings, period. 

Shouldn’t Bloomberg and Factset math be illegal? This stuff happens prior to every crash, manipulating the numbers, like Fitch giving A ratings on CDOs. Out of 1000 investors, I’m probably the only guy who notices this stuff. That doesn’t really make it fair for the 999.

I remember this from 2008/09. Here’s Siegel (not that I subscribe to his views, necessarily) with a counter:

http://www.wsj.com/articles/SB123552586347065675

It’s whatever, just make it count.

- kDot

purealpha wrote:

As the guy who checks people’s math, I would like to point out that Bloomberg are blatantly manipulating statistics, again.

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“On a share-weighted basis, S&P 500 profits were down 3.3 percent on year in the third quarter, marking a second consecutive quarter of negative earnings growth.” http://www.bloomberg.com/news/articles/2015-11-23/s-p-500-profits-fall-2...

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Wrong, Q3 earnings were down -14% YoY, marking a fourth consecutive quarter of negative earnings growth (per real math, which can be found in S&P’s excel download). Bloomberg share-weighted to get their number, which is NOT a proper method to use (explained by S&P here), and they did so in order to underrepresent the energy sector losses. Index earnings are simply the sum of the 500 earnings, period. 

Shouldn’t Bloomberg and Factset math be illegal? This stuff happens prior to every crash, manipulating the numbers, like Fitch giving A ratings on CDOs. Out of 1000 investors, I’m probably the only guy who notices this stuff. That doesn’t really make it fair for the 999.

They should be made illegal because their earnings growth methodologies differ from yours?



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Galli wrote:

They should be made illegal because their earnings growth methodologies differ from yours?

Maybe you aren’t good with basic math. Well, you have a lot of company, especially in the USA! ;)

Their “earnings methodologies” are picked from the available methodologies because they produce the most favorable result. The normal methodologies, which would generally be used if a source was objective, are ignored and those numbers NEVER quoted…they are intentionally hiding the real numbers from the public, to prop up markets (just as we saw with CDOs and other instruments in the past). And besides, the chosen methodologies and simply mathematically WRONG, as explained by S&P in the link above.
 
It’s not okay, and anyone who passed quant should know this is a serious violation of what ought to be (but clearly is not), common math-ethics.

EconomistAnalyst wrote:

More importantly: Inflation won’t be going anywhere. As long as inflation rates in EMU/US are so low rates are going to stay low.

I am not that sure that this is the case in the US. Yes, headline CPI is close to 0 at the moment but this is due to the energy price collapse and this effect will diminish in the next couple of month…if WTI is stabilizing at the current level that is. Core CPI is close to 2% and Shelter is also strong. http://jeroenbloklandblog.com/2015/11/20/8-charts-to-show-inflation-is-not-dead/

purealpha wrote:

Galli wrote:

They should be made illegal because their earnings growth methodologies differ from yours?

Maybe you aren’t good with basic math. Well, you have a lot of company, especially in the USA! ;)

Their “earnings methodologies” are picked from the available methodologies because they produce the most favorable result. The normal methodologies, which would generally be used if a source was objective, are ignored and those numbers NEVER quoted…they are intentionally hiding the real numbers from the public, to prop up markets (just as we saw with CDOs and other instruments in the past). And besides, the chosen methodologies and simply mathematically WRONG, as explained by S&P in the link above.
 
It’s not okay, and anyone who passed quant should know this is a serious violation of what ought to be (but clearly is not), common math-ethics.

You’re either a tool or frustrated with your positions. No (successful) trader complains about market methodologies they find to be wrong, they simply exploit them and keep quiet.

Galli wrote:
You’re either a tool or frustrated with your positions. No (successful) trader complains about market methodologies they find to be wrong, they simply exploit them and keep quiet.

Clearly that is not correct, since I exist; I exploit industry propaganda and talk about it.

Go back to the CFA books kid; mutual exclusivity, ETHICS, quant, etc.

I don’t work for bloomberg nor use their data - completely irrelevant to me if their data is accurate or not.