S&P 500 Fair Value: What to Expect in 2011

About two years ago I posted my mathematical assessment of the market's fair value. It's still a widely-referenced article. Given your interest and my own curiosity as I prepare my investment route for 2011, I thought I'd repeat that study using more recent data.

But this time, I'll use both a dividend discount model and an earnings growth model.

S&P 500 Fair Value from a Dividend Perspective

Using the Dividend Discount Model here's a quick summary of the market today and what is in store for 2011, if history helps.

If we treat a stock as a bond and nothing else, we're expecting to get in the future our model for dividends  that we got in the past, plus some growth. This is one of the most conservative ways I know to value a stock and hence why I'm using it here to value the index.

Here are the numbers:

1. All-Time Dividend Growth. Since 1960, the S&P 500 has grown dividends an average of 5.04% per year (note: variance is large, meaning some years this number is much higher, others much lower).
2. 10-Year Dividend Growth. The last 10 years have seen a lower dividend growth, just 3.58% annually.
3. Today's Fair Value. Assuming a 5% growth ad infinitum a 7.5% discount rate based on an estimated dividend for 2011 of $24.28, today's fair value is 971, meaning the market is overvalued by 33%.

Modeled value vs. real value for S&P 500 using DDM.

S&P 500 Fair Value from an Earnings Perspective

Earnings provide another way to assess the fair value of an index. By looking at historical growth and current earning yield, we can put a fair price on the index. However, earnings are a secondary measure of what one can get out of an index, since not all earnings flow to the investor as dividends. 

While earnings can give us a good feel for how the market is doing, it can't tell us what the companies will do with their earnings nor how they will return them to us investors. Dividends can be cut, but earnings are flakier, given that they're not usually thought as belonging to shareholders, which is a shame, but quite true of most companies.

Here are the numbers:

1. All-Time Earnings Growth. Since 1960, S&P 500 earnings have grown an annualized 6.81%.
2. 10-Year Earnings Growth. For the trailing 10 years, earnings have grown 4.07%.
3. Today's Fair Value. Assuming 2011 earnings of 87.84 and applying a P/E multiple of 15, the S&P would be valued at 1318 today, meaning the market is undervalued by 1.7%.

Modeled value vs real value for S&P 500 using earnings.

Conclusion

Whether you choose to believe the DDM is more accurate or the earnings approach is more accurate, both currently indicate that the S&P is anywhere from fairly-valued all to the way to grossly overvalued.

However, this numerical assessment assumes a smooth continuation of history without taking into account all that is going on with the economy, international affairs and expectations of inflation/deflation.  Use this to help you make informed decisions, but do not rely entirely on it.

The source of raw data is still here (no affiliation with the authors or their institutions).

Disclosures: I own SPY and many other whole market-tracking indices at the time of writing.

Preparing a Shopping List for Bad Times Ahead

Several pundits online and on mainstream media are calling for another "leg down" or plain depression in the markets soon.

I don't react to predictions, forecasts, star readers or fortune tellers. I will see when it happens. However, it's always good to be prepared for anything -- up markets, down markets, neutral markets -- at all times. As such, I have my shopping list ready in case the forecasters turn out to be right.

Because it's a long shopping list and it's mostly still far from my entry prices, I will just pick those that have been approaching my entry price recently. Many of these are names I already own and am looking to buy more of. Some are new.

Shopping list for the next "leg down"

PAYX (Paychex) - Buy range: $25-21, Current: $25.47
COP (ConocoPhillips) - $47-38, Current: $48.82
PFE (Pfizer) - $13-11, Current: $14.14
RDS.A (Shell) - $48-42, Current: $50.01
CINF (Cincinnati Financial) - $23-21, Current: $25.53
ETR (Entergy) - $75-60, Current: $70.70

Note 1: These are all dividend payers that have been around for a while and paying dividends for a while.

Note 2: Entry prices were based on my model of discounted dividend analysis and a qualitative assessment of earning power. The entry prices typically entail a total return from dividend plus dividend appreciation to 11 to 12%. Any share price growth is extra icing on the cake (and was not factored in the price).

Note 3: There are two oil companies on the list. This is a good thing, because when governments in developed countries start to print money seriously, oil, gas and tanker and pipeline companies will benefit. It's best to own the companies behind these commodities than own the commodities outright for various reasons that are beyond this article's point right now.

Note 4: I started buying Shell a little ahead of my entry price and am looking into buying more significantly when it does enter the buy range.

Note 5: I haven't bought Entergy yet because I haven't had time to investigate their price drop and read their latest 10Qs. As soon as I find out they're still in as good a shape as when I first priced my buy range, I will pull the trigger.

Disclosures: I own shares of PAYX and RDS.A at the time of writing.

Professional Opinion-Givers Always Have Opinions

I'm not a big fan of just criticizing. I prefer to offer better alternatives. However, today I'd like to criticize the financial media in general.

It's not that there isn't news to be reported or information to be shared. It's just that the noise-to-signal ratio is too high to have much value, unless one has special talent in tuning out the noise.

I believe the main reason for all the noise is that opinions are free and everyone has one. Moreover, when financial reporters are paid big bucks to have an opinion, they're guaranteed to have one, and possibly a different one every day, since old news is, well, just that.

When people in general focus on what they do everyday they often get so specialized that they forget that their world is not the whole world. When I go see my optometrist, she tells me to wash my eyelids 3 times a day with warm, soapy water. My dermatologist suggests that I wear sunscreen everyday, even if I spend the whole day indoors inside an office. How many times would a dentist recommend one flosses and brushes? And yet, by eating right and exercising I'd have a much bigger payout in terms of long-term health than following all the specialists' recommendations.

Likewise, financial reporters must talk about the market. And so they do. If it's going up, there's a reason for it. If it's going down, there's another reason or sometimes the same reason as yesterday -- "investor's sentiment", they'll say.

Over-analyzing stock charts and daily fluctuation of the markets has been shown time and again to be foolish. It only tells you what the majority of the market participants (by volume of money, not number of people) think the right price for the market is. Everyone has an opinion, and by following the opinion of the average market participant or that of the financial reporter at best only guarantees you're one step behind everyone else. At worst, it leads to financial destruction.

You should have your own opinion and not let those paid to have opinions -- whether the opinions are right or wrong -- guide how you should invest your money.

What to do then?

Collecting data and analysis based on data is the first step to forming your own opinion. There are respectable services out there that can help with that, such as Morningstar and Standard & Poors. However, none of these should be used as the final decision. Blindly following their star ratings is a recipe for disaster, no matter how well-trained the analysts might be.

Why?

Because it's not their money that is on the line. It's yours.

Second, because often times the recommendations are delayed, or are not updated frequently or both. And on top of that, their criteria for what a suitable investment might be is most likely completely different than yours.

As a matter of example, consider S&P's star rating system. S&P claims that their 5-star recommendations beat the market over time. But is this purely due to enlightened analysis or some amount of hindsight? After all, not everyone can beat the market by following S&P's 5-star recommendation or that would be the market's return.

The following is a chart of WMT as provided by S&P's free stock report, which can be obtained from many known online brokerages.

The red ellipses are my addition highlighting periods where their target price tag (the line in orange) changed. Were these changes due to some clever insight or a knee-jerk reaction to the price change? Is it really possible to beat the market by being one step behind it? I'll let you be the judge of that.

In summary: turn off the TV and tune out the noise. Use analysis services as necessary, but as a source of information, not as a recommendation.

Disclosures: I own WMT at the time of writing. I was not compensated in any way for mentioning the names of the companies mentioned above.

Free Market Commentary Usually as Good as Its Price

Don't believe everything you read out there. Errors, omissions and mistakes abound. Here's is this week's example. Consider this news article by Zacks, "Brazilian Manufacturers Slightly Relieved".

The news piece claims that some Brazilian companies should benefit from consumer spending, "These include home appliances retailer Companhia Brasileira de Distribuicao (CBD), [...] cement maker CEMEX S.A. de C.V. (CX) [...] and state-owned steel producer Companhia Siderurgica Nacional (SID) ".

Wait a second.

CBD is not a "home appliances retailer". It's a supermarket chain.

CEMEX is not a Brazilian company either. It's Mexican.

SID is not state-owned and hasn't been since 1994.

And this comes from a "respectable" market and security research company.

Is this even relevant to the article's point? Probably not. But these errors are so simple and straightforward to catch that they show no editorial quality control whatsoever.

If this were the only example where errors, bad data or bad advice happen on the Internet (or on TV or other media in general) we'd probably be okay. But beware, it's out there. This one was only too obvious not to comment.