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Kass: Fair Market Value Update

This year, the S&P 500 dramatically eclipsed my calculations of fair market value, owing to both an expansion in P/E multiples and a better corporate profit performance. (One third of the S&P's better rise was due to higher profits and two thirds was due to an expansion in multiples.)

A year ago, my baseline expectation for 2013 S&P profits was between $100 and $102 a share.

Today, as we near year-end, the consensus estimate for 2013 S&P earnings is $109 a share. I am now at a below-consensus forecast of between $107 and $109 a share.

For 2014, the consensus estimates that the S&P 500 will achieve profits of about $116 to $118 a share. My base case estimate is for $112 to $114 a share, a gain of under 5% (year over year), which is, again, below consensus.

Slowing sales, a contraction in margins, the reduced influence/benefit from aggressive monetary policy and political uncertainties are some of the reasons why my baseline earnings expectation are for below-consensus 2014 S&P 500 profits.

Today's new fair market value calculation of 1645 incorporates the following:

  • the melded probability distribution of my four scenarios (below);
  • reflecting the continued and surprisingly low-interest-rate environment, I have increased the P/E ratios applied to each of the four outcomes from my previous fair market value calculation; and
  • profit forecasts for 2013-2014 have been revised upward to reflect what has been reported and earned thus far in 2013.

Since I began this exercise several years ago, I have tried to be consistent with methodology, reasonable in my profit forecasts, and I have applied sensible valuations. Again, I want to emphasize that my methodology, though appearing precise, recognizes the difficulty of attaining investment precision given the numerous moving parts (economic, interest rates, sentiment/psychology, political outcomes and other exogenous factors) in its calculation. It is intended more as a thoughtful guideline (of reasonable expectations/outcomes) than an exercise that should be taken literally. (I strongly recommend that subscribers input their own probabilities and outcomes in order to produce their own market expectations.)

Scenario Analysis

"A good forecaster is not smarter than everyone else; he merely has his ignorance better organized."

-- Anonymous

Below are the criteria and methodology I use to evaluate the S&P 500 and upon which I conclude that fair market value is approximately 1645 (it is overvalued by about 5% compared to Friday's close of 1740).

Scenario No. 1 -- Economic Reacceleration Above Consensus (5% probability): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts (3%-plus 2014 real GDP growth) based on pent-up demand in nondurable spending (cars and autos), rising consumer and business confidence and a sustained period of low interest rates. Corporate profit margins are preserved. The Fed begins tapering in January 2014. European economic growth rises to above 1% in real terms, and China's growth rate exceeds 8%. The disruptive influence of our politicians in Washington, D.C., is diminished and fails to adversely influence business/consumer behavior. The yield on the 10-year U.S. note exceeds 3.5%. S&P 500 profits for 2014 approach $120 a share. P/E multiples average 16.5x, producing a 14% 12-month upside. S&P target 1980.

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