Tuesday, March 29, 2011

Capitalized Corporate Profits Model

As corporate profits continue to hit all time highs, thought it was time again to review market valuations. While most investors expect higher year end stock valuations, most only expect modest gains from current levels because the market has run to fast since the March 2009 lows. As we've said on the this blog for the last couple of years, its not wise to use that panic low as a basis for historical measurements and average returns. The market collapsed like never before and should also rebound in a like manner.

The SP500 is still considerably below its October 2007 high even though corporate profits have already surpassed those levels. Of course, valuing a market in the vacuum of a single data point can be dangerous. This is why the capitalized profits model factors in the 10-year Treasury Yield to calculate the estimated market valuation. Naturally lower rates should mean higher valuations as stocks become more attractive then bonds.

Ironically from the chart below, the SP500 has trended flat to down over the last 11 years as the 10-year Treasury Yield has slid from nearly 6.5% at the 2000 peak to 5% at the 2007 peak and all the way down to the current 3.5%.

Using the corporate profits model, First Trust calculates the fair value of the Dow to be 22,800 with the Treasury yield at 3.5%. Naturally the problem with very low interest rates is that most people in the market won't trade based on them and rightfully expect rates to rise significant if the market was to approach old highs. Accordingly the team of Brian Westbury and Bob Stein used a Treasury yield of 5% to generates a "fair value" of 16,000 on the Dow and 1715 on the SP500.

Those numbers are substantially higher then existing markets with the SP500 around 1315 today or a gain of roughly 30%. Naturally the market brushes such estimates off and continues to focus on the downside potential with supposed black swans around every corner. By the way, the tsunami/earthquake/nuclear crisis in Japan and the fighting in the Middle East and North Africa are no where close to black swan events. Short term disruptions that impact relatively small areas of the world won't disrupt the global growth thesis.

Naturally its never wise to pick a valuation thesis and just blindly follow it without ever questioning the continued validity. If the facts change, as an investor you should be willing to adjust as well. This model would've never predicted the 2008 market collapse. Neither would've most models since its difficult to predict a financial collapse or black swan event. Regardless, while looking for the next black swan make sure you understand that absent such an event the market appears headed to all time highs as record corporate profits are expected to continue expanding and are back dropped by ultra low rates. Ask yourself, why wouldn't the market hit all time highs?

Chart courtesy of chartfacts.com.






Disclosure: No positions listed. Please the disclaimer page. 

1 comment:

Joseph Russo said...

If a company were to use its earnings to repurchase half its shares, the market would be crazy to not double the price of the shares, because EPS would also double. PE ratios and earnings yields, all else being equal, should therefore not be affected by share buybacks. PE ratios remain a valid source of valuation information even in the presence of massive buybacks.
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