"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 four 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. Remembering the phrase that if you have to forecast, forecast often, I will attempt to update my fair market value every month or so in 2014 or as circumstances change. Late last year, I expressed the view that a domestic economy incapable of reaching escape velocity would produce a challenging earnings landscape. This, to me, represents the continued threat and principal enemy to the U.S. stock market for 2014 and forms the basis for my four core scenarios (economic, earnings and market valuation) that has 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 -- others include 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 investors (and the Fed) have 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.
"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 1650 (so the S&P is overvalued by about 10% compared to Tuesday's close of 1845):
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. Whether one is gazing at charts or incorporating fundamentally based discount models, all too often technical and fundamental analysts proclaim precision of market forecast. Frankly, I view those pronouncements as laughable. There is no special sauce, fractal or system to beat the market and to forecast its future with consistent accuracy -- if there was, Steve Cohen, Lee Cooperman, George Soros or Paul Tudor Jones would have purchased the recipe. I use this morning's exercise as a guide to portfolio management. Again, it is certainly not meant to be an exercise in precision, but I have found this calculation, over time, to be a generally good discipline that keeps me honest.
The Market Is About 10% 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 Buffett'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% to 10% 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 10% overvalued, why have any investments in equities? Why do I have more long ideas on my Best Ideas list than short ideas? 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.
This column originally appeared on Real Money Pro at 8:16 a.m. EST on Feb. 26.