S&P 500 Fair Value: "Have it Your Way"
Q1 2012 Update
By Chris Turner
June 5, 2012
Now that nearly all S&P 500 companies have reported earnings for the first quarter, I've updated my previous Fair Value Analysis to include the new data.
As a reminder, there are many great methods for valuing the S&P 500. One of the most common valuation metrics familiar to Advisor Perspectives readers is the one popularized by Yale Professor Robert Shiller. The chart below shows the monthly average of S&P 500 closing prices divided by 10 years average earnings and adjusted for inflation based on the Consumer Price Index (CPI) and earlier pricing data for the period before 1913, when the Bureau of Labor Statistics took on the task of creating this indicator.
Professor Shiller's latest chart (as of June 1st) puts the current P/E ratio at 19.99. The Long Term Interest Rates reside in the background and pose no significant contribution to the chart except for general informational purposes. A quick glance at the data from his Excel file displays the "problem" with the chart however.
Attentive Excel users will quickly discern that his cyclically adjusted P/E of 19.99 neither includes earnings from Q1-12 (currently at 88.40 on the trailing twelve months basis) nor the estimate for Q2-12 (currently at 92.49). The next view simply shows how the 19.99 is calculated:
Note that Prof. Shiller uses 10 years of CPI adjusted data, well, almost 10 years. By "fixing" his data, we would see the following and a corresponding number to the final tally for Q1 2012:
The items in yellow have been added to complete his series. Keep in mind that 19.99 reflects the price on June 1st. I placed the long term average over on the right just to show the relative historical valuation (16.44).
The following chart simply removes the long term interest rate and replaces with just the simple nominal Price to Earnings ratio.
Readers may be surprised to see that the inflation-adjusted and nominal versions correlate rather well. Professor Shiller uses the real calculation to determine how much over- or under-valued the S&P index is by comparing the current PE (22.05) to the long term historical PE (16.44).
Some may find futility in trying to determine exactness out of Shiller's Product, but by simply applying some math and placing his data on steroids, his chart has more meaning.
The red line now represents the S&P 500, the Blue line does the math for you to show exactly where "fair value" should be on a monthly basis (Equivalent Fair Value). For the chart-challenged, the box provides context toward the exactness we strive to find.
The following chart displays the nominal calculation. The scale looks different simply because back in 1881, the S&P Composite was actually around 6 rather than the CPI adjusted S&P composite of 130.
No surprise here. Both show the S&P 500 would be fairly valued around 1000 (or just a few flash crash days away). Is there any magic to 10 years? Liz Ann Sonders recently remarked on Bloomberg that 5 years might be an interesting study. Well, the following table should just about cover every time period one might desire and applies both nominal and CPI adjustments for good measure.
The table presents time periods that should suit any individual's preference. In an effort to create the ultimate "fair value" indicator, the addition of three metrics seemed warranted, a monthly PE value, the use of Earnings Yield, and some sort of "sentiment" indicator.
First, the monthly P/E averages simply use the monthly averages of daily closes (in this case 1389) divided by monthly earnings (88.40) to provide the monthly P/E (15.71). This number is then averaged for respective time period (i.e. price divided by an average of 5 years of monthly P/Es). Note that the 5-year chart below tracks the S&P relatively well.
Second, many like to use the current earnings yield for valuation purposes. Why not average those in as well? The following chart uses 5 years of earnings divided by current price to arrive at a valuation.
The last indicator used would be something that reflects "sentiment", which, for better or worse, is where supply meets demand for prices. Quite simply, sentiment is the S&P 500 index itself. In the table, sentiment over time is represented in the average of monthly closes.
Combining all the indicators over various time periods produces the Combined Fair Market Value, shown below.
Based upon the combination of all the indicators and across all time horizons, the S&P 500 index remains overvalued by a substantial margin. Consider this data simply as information that provides a snapshot of historical relative valuation rather than "tradable" ideas. Investors should understand that knowing a "fair value" target provides an educated backdrop for making "investments" or "trades." But as the charts and tables above illustrate, the market can remain over- and under-valued for long periods of time. The full report with all the charts is located here. We can revisit this fair value table as earnings season progresses throughout the year.