|Reversion to the Mean |
S&P 500 Year-Over-Year Change Since 1950 -- 8.9% Average
The nearly unbroken streak of positive returns from January 1991 through October 2000, followed by nearly three years of negative returns, is aberrational. Even after the recent rally, the S&P 500 is still 10% below May 2002.
|S&P 500 Since 1950 |
This chart shows actual results of the S&P 500 vs. two trend lines. After getting ahead of itself in the late 1990s, the S&P 500 appears to be about 40% undervalued, at least compared with the long-term trend. It's instructive, however, to convert such graphs to log scales (which make similar percentage moves look the same).
|S&P 500 Since 1950 |
This chart shows that the S&P 500 grew above trend for most of the 1950s and 1960s, then grew below trend for the following 20 years. Because the two above-trend periods were the great economic boom of the 1950s and 1960s and the Internet bubble of the late 1990s, it is quite conceivable that future growth in the S&P 500 will be less than the 8.9% average, more like 6% or 7% a year.
Fed ModelSimply examining long-term growth rates doesn't take into account changes in interest rates. The Fed model attempts to value the S&P 500 on the basis of the yield on the 10-year Treasury, combined with one-year forward expectations about S&P 500 earnings.
|% Diference Between S&P 500 vs. Fair Value |
In this chart, we see that the last time the S&P 500 was as much as 40% undervalued was after the great bear market of 1973-4, which makes sense given that the recent peak to trough decline in the S&P 500 was about the same magnitude, and the Nasdaq fell by an astounding 75%. Even after the recent rally, this model estimates that the S&P 500 remains undervalued by 33%, assuming yields of 4.75% and could be undervalued as much as 50% if yields remain around 3.5%. The two drivers are forward one-year estimates of S&P 500 earnings and estimates of yields on the 10-year Treasury. If you play with the
|Tobin's Q |
|Source: Smithers, Wright -- Valuing Wall Street|
Tobin's Q is a model which says that the value of the overall stock market should equal the replacement value of the publicly traded companies -- i.e. (Market capitalization) / (net assets - net liabilities) = 1. The 1970s and early 1980s was the era of the leveraged buyout because it was cheaper to buy assets than build them. As with other models, the peak divergence occurred around March 2000. Now that the ratio has fallen back to 1, this model indicates that the risk of investing in stocks has been reduced substantially but still may be high.
|Ratio Stock Market Capitalization/GDP |
Ratio Stock Market Cap to GDP -- Average 64%
Like Tobin's Q, this model assumes that there should be some link between stock market valuation and something tangible -- in this case the gross domestic product (GDP) of the U.S. The ratio averaged 64% over the last 50 years, then tripled during the Internet bull market. Through the March GDP report, the ratio fell back to 91%, which implies that the S&P 500 is still overvalued by about 50%. The counterargument is that because a large portion of stock market earnings are now derived from overseas activities, perhaps this model needs to be adjusted to take into account world GDP.