Putting a Fair Value on the Stock Market

Putting a Fair Value on the Stock Market

As stocks are bouncing along their bottoms for the year, we are left to conclude that buyers must be on vacation. The lethargic stock market performance certainly cannot be attributed to a problem with economic fundamentals. The economy is showing anything but “dog day” attributes.

Corporate profits have been on a tear as the economy continues to improve. Through the end of the first quarter of 2004, corporate profits were up an impressive 32.3% on aggregate from the same period a year ago. Those numbers represent the strongest growth rate in two decades. With final figures not in yet for the 2nd quarter, impressive earnings reported over the past several weeks suggest that profit growth remains strong. As of the last quarter, Economy.com estimates corporate profits were up 20% every year from the previous year.

Reading between the lines, I am encouraged to conclude that the economy is making a gradual transition from its initial blast-off stage coming out of the 2001–2 recession to a more solid, sustainable rate of economic expansion.

Under “ordinary” circumstances, the lack of enthusiasm for buying stocks might be attributed to the slower underlying earnings growth of stocks. This does not seem to be the case today when looking at the S&P 500. For most of 2004, the P/E of this index of the largest group of publicly traded companies has been below 25, leaving it well below the elevated levels of much of the last decade. Based upon reported earnings growth it appears that the E in P/E is finally catching up with the P.

If the market is the great predictor of the future direction of the economy, we might be looking at a slow-down. But this is an economy that has begun creating jobs, which points to a self-sustaining expansion. Granted that the rate of growth is slowing, but that is to be expected as a growing economy gears for the long run.

Rising interest rates could be putting a damper on enthusiasm for equities. But the Fed expressions of “measured trajectory” for increased rates from a base already low by historical standards should provide a credit environment conducive to continued expansion and growth of corporate profitability.

From this perspective we might conclude that the market is undervalued. We can test this theory using what is known as the Fed Model for the fair value of stocks. While the Fed officially has never acknowledged that it has a fair value model of stocks, the framework for determining the appropriate valuation for stocks was discovered in the Fed’s July 1997 Humphrey-Hawkins report, and the label “Fed Model” has been attached ever since.

This report observed that the ratio of forecasted earnings one year ahead to stock prices is highly correlated with the yield on longer-dated Treasuries. Using the Fed Model, stocks were approximately undervalued during the Long Term Capital Management Crisis of 1998 by 21%, and overvalued just before the bubble of 2000 by 65%.

Using the following assumptions to approximate today’s situation, a 10-Year Treasury at 4.4%, the S&P trading at 1080 and the forecasted forward earnings for the S&P of $65 a share (Thompson Financial estimates through June 2004), the Fed Model says the market is undervalued by 26%.

I don’t mean to imply that the market will quickly jump 26% . . .because this formula has its flaws. For example, the Model does not take into account investor preferences for risk premium. During periods of higher uncertainty, investors demand a greater premium over the return offered by risk-free Treasuries. Today we have uncertain times, and that may explain why this market does not reflect the theoretical fair value.

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