"We believe that short-term forecasts of stock or bond prices are useless. The forecasts may tell you a great deal about the forecaster; they tell you nothing about the future." -- Warren Buffett's letter to Berkshire Hathaway ( BRK.A)/ ( BRK.B) shareholders, 1980Forecasting prospective market levels out 12 months is an imprecise art form that requires probabilistic decision making, using imperfect information about an inherently unknowable future. Forecasting market levels out beyond 12 months is, to me, more a function of one's philosophy than an investment prediction. But try we must (especially over the next 12 months) even despite The Oracle's protestations. It has been nearly nine months since I last published my estimate of the S&P 500's fair market value, but I am going to give it a go again this morning (with the insistence from subscriber Renato, who sent me a nice note recently). Remembering the phrase that if you have to forecast, forecast often, I will attempt to update my fair market value every month or as circumstances change. Early this year, I expressed the view that a domestic economy incapable of reaching escape velocity would produce a challenging earnings landscape. This, to me, represented the principal enemy to the U.S. stock market for 2013 and formed the basis for my four core scenarios (economic, earnings and market valuation) that yielded my fair market value calculation. Anemic top- and bottom- line growth in corporate sales and profits were by no means the only factors that contributed to my valuation concerns this year as was the growing evidence that aggressive monetary policy is losing its effectiveness and that our leaders are failing to address our deep-seated fiscal issues. Instead (and out of necessity), our authorities placed ever more pressure on our monetary policymakers to bear the responsibility of bringing our domestic economy out of its doldrums. After nearly five years, the results barely met a passing grade and uncovered the depth of our structural headwinds that have been ignored for so many years (e.g., disequilibrium in the jobs market, screwflation of the middle class, financial repression penalizing the savings class, etc.), and once again, the Fed has overestimated U.S. economic growth and the positive impact of trickle-down economics (through the lifting of asset prices). Forecasting is the art of saying what will happen and then explaining why it didn't. While my fundamental observations (and headwinds) still seem materially correct, my assumptions for a contraction in P/E multiples were wrong-footed as were my market conclusions and S&P price targets.
- 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.
"A good forecaster is not smarter than everyone else; he merely has his ignorance better organized." -- AnonymousBelow 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.
How Do I Use My Fair Market Value Exercise in Actual Practice?
"He who lives by the crystal ball soon learns to eat ground glass." -- Edgar R. Fiedler in "The Three Rs' of Economic Forecasting -- Irrational, Irrelevant and Irreverent" (June 1977)The investment mosaic is a complicated one; it makes the riddle of the Sphinx seem simple by comparison.
The Market Is Moderately Overvalued
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands. -- Warren Buffet's letter to Berkshire Hathaway shareholders, 2000I continue to see the stock market as being moderately overvalued -- the higher we go from here, the line between speculation and investment seems likely to be increasingly blurred. In the past, I have suggested that in a 5% overvalued market, a conservative investor should not be more than 50% long -- and I still stand behind that. So, if I believe (as I currently do) that the market is slightly more than 5% overvalued, why have any investments in equities? The answer is obvious. At any given time (regardless of where the market is selling), individual stocks are overvalued and undervalued. This is particularly true today since there is so much uncertainty in fiscal (and monetary) policy, in political/economic outcomes and with regard to business and consumer reaction to policy. Don't take my word for the fair market value calculation. Again, I strongly encourage you to input your own earnings/economic/multiple expectations and create your own fair market value calculation. This allows investors and traders to pick sides on the issues and make their bets a bit more intelligently, particularly on the broader market. I hope you find this exercise to be helpful as a guideline.
This column originally appeared on Real Money Pro at 8:24 a.m. EDT on Oct. 21.