Author: CJ Brott, Capital Ideas
Covestor model: ETF Only and Macro Plus Income
Disclosures: None
My thesis revolves around a variation on the “Fed Model” of interest rates and market PE ratios. Basically the original model used the rate on the ten year US Treasury note to determine a proper level for the PE of the S&P 500. The formula was basically as follows:
S&P 500 PE = Inverse of US Ten Year Treasury Rate
However two problems arise with this model. First, exceptionally low Treasury rates may indicate ridiculous PE ratios. Second, the Fed’s continual easing has created a Treasury rate no longer linked to market risk.
To bring the model back to reality an interest rate reflective of market risk is needed. I have found the rate on Baa corporate paper correlates well with an S&P PE based on operating earnings. Using data derived from the Federal Reserve, Bloomberg, and S&P in the model I have found it to project forward PE’s within acceptable ranges. These levels tend to be relatively predictive of future market levels.
For 2011 many market strategists are predicting S&P 500 companies earning in the aggregate around $99 – 100 per share. I have been using $93 to $95 in this model. Given Baa rates averaging 6.25% for 1H 2011 the market’s year- end level should be approximately 1500. That is about 15% higher than the current 1300 range (as of 7/14). Even with the slow economic growth currently being predicted, next year’s S&P earnings could easily rise 10% to approximately $105 per share. If Baa rates rise from the current levels to average 6.5% that would still imply a PE of 15.5 for the S&P and a price level of about 1625. Given that the current S&P is 1300 is a 25% rise by year end 2012.
This model is a longer term valuation model and is not intended for short term market timing. However, during times of extreme market volatility it is valuable to aid in uncovering extreme mispricing. For example, in March of 2009 it implied an S&P level 25% higher by year end. That proved to be quite accurate. While the current market level is now double that March low, corporate earnings continue to grow. And although Europe may melt down or the US might default on its debt, those outcomes are unlikely. The best odds going forward appear to be betting on a market driven higher by valuation, not one driven lower by the potential bad news.
Sources:
“Fed Model” Wikipedia. https://en.wikipedia.org/wiki/Fed_model
“Analysts Double S&P 500 Sales Forecast as Margins Stagnate” Bloomberg Businessweek, 7/27. https://www.businessweek.com/news/2011-06-27/analysts-double-s-p-500-sales-forecast-as-margins-stagnate.html
Baa rates from Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/series/BAA
