Current SP valuation

[SomeDude]

This isn't a prediction of where the price is going. After reading through lots of threads, some people seem to get triggered when people do that.

For about a year now I've been modeling what is the historical fair value of the S&P 500 against 6 equally weighted factors. I measure the historical average value of the metric divided by the current value, multiplied against the current price to get a fair value price based on each metric. Then i take the average of the six.

The metrics are: P/E, shiller P/E, div yield, price to book, price to sales, and buffet indicator (total market cap divided by GNP).

I do it every Saturday. In the middle of the year, the metrics were pointing to about 1950 as fair value. As gdp and earnings continue to drop, its now saying 1860 as fair value historically based on the fundamentals.

Again, not a prediction of where prices will go. Clearly the market price suggests a huge increase in earnings coming. Even still, big returns for the S&P over the next 5-10 years "seem" highly unlikely.

Anyone else think the prices are silly high?

[pmward]

I think the thing most fundamental investors forget is that price only really matters maybe 5% of the time total. In the middle of a strong bull market valuation does not matter at all. Eventually one day we will reach a point when valuations matter again. But in the meantime, as long as sentiment is strong enough stocks will continue to get more "overvalued". So who knows how high it can go? Using some basic Fibonacci stuff, from the 09 bottom it's entirely possible we could reach S&P 5,000-6,000 before this secular bull market truly comes to an end. Now, I'm not saying that is for sure what will happen, and if it does it won't go there in a straight line of course, but it is possible. So sure, anyone using "valuation" will suddenly look smart after we peak and the new secular bear market begins. But how smart would it have been really to sit out the market doubling just to look smart when the market starts to decline?

"When I see a bubble forming, I rush in to buy" - George Soros

[Hal]

[Smith1776]

I love the assortment of indicators. That kind of data has always been my jam.

It seems though that there's no inclusion of interest rates into the valuation. I personally think that when one factors in the current low interest rate environment, stock valuations are perfectly reasonable. Maybe even a little on the cheap side.

[SomeDude]

I love the assortment of indicators. That kind of data has always been my jam.

It seems though that there's no inclusion of interest rates into the valuation. I personally think that when one factors in the current low interest rate environment, stock valuations are perfectly reasonable. Maybe even a little on the cheap side.

Why do you think these ultra low rates make these incredibly high valuations seem cheap? Do you think that means stocks are likely to have good long term returns in the next ten years or just relative to bonds?

Didn't buffet say "in the short run, the stock market is a voting machine, in the long run it's a counting machine". Where will the earnings come from to justify these prices?

[Hal]

Great Avatar Smithy

You probably know this already, but just in case....
https://www.youtube.com/watch?v=bO_JqQzn1lU

[pmward]

I love the assortment of indicators. That kind of data has always been my jam.

It seems though that there's no inclusion of interest rates into the valuation. I personally think that when one factors in the current low interest rate environment, stock valuations are perfectly reasonable. Maybe even a little on the cheap side.

Why do you think these ultra low rates make these incredibly high valuations seem cheap? Do you think that means stocks are likely to have good long term returns in the next ten years or just relative to bonds?

Didn't buffet say "in the short run, the stock market is a voting machine, in the long run it's a counting machine". Where will the earnings come from to justify these prices?

I totally concur and the issue comes down to the way stocks are valued based on a discount rate which is assumed constant over the period of cashflows.

Using current interest rates might be agnostic so that there is equal odds of interest rates rising or falling but this again brings us back to the negative rates discussion.

Do not forget, from a stock market (and gold) perspective, nominal interest rates are not the proper metric. It's always real interest rate that matters. As long as we are in a negative real yield environment the sky really is the limit for stocks. There is technically infinite upside in a negative yield environment. And eventually when real yields do turn positive and start going up (will the Fed even let that happen?) obviously we will have a strong 2000 like re-valuation. But for the moment, given poor demographics, historically high debt loads, and a global trend towards yield curve control that the Fed would likely turn to if rates did start turning positive again, I would say the likelihood of that happening in the next few years is low. Not impossible, but extremely low.

Now, yields have been turning less negative in recent months due to increasing economic expectations. A "reflation" is being priced into the market over the next ~2-3 quarters, which makes sense since 2020 left a real low bar to beat as well as historically strong pent up demand that will be unleashed in a post-vaccine world. This is the reason why gold has been struggling but stocks have not. Stocks don't just have the interest rate factor, they also have the economic factor. Since the economy is looking up the next few quarters, stocks can ignore rising yields and still rally, mostly through the most "oversold" "value" stocks and sectors playing catch up. Gold on the other hand is going to continue to struggle through the reflation, as rates continue to go less negative. But, the "reflation" is likely just a countertrend move in the broader deflationary cycle going back 13 years now, not unlike the counter-trend reflation in the 2017-2018 timeframe. I fully expect the deflationary trends to take back hold in the next year or two. I just don't think long term yields are going to come this close to 0 and not actually touch it. I think 0% 10 and 30 year yields are inevitable, and that will be good for both stocks and gold... at least until we hit 0. If rates don't go negative (ie they stay at 0) and deflation continues, that leads to a rising real interest rate even though nominal rates are stable... and that is when reality could really sink into stocks (and gold would also have a real bad time). The thing to fear isn't negative rates, its yields hitting 0 across the curve and stopping. If the Fed didn't go negative, this would basically be forced austerity.

That's just my .02 though. I don't think there is any evidence that the deflationary trend is over yet, and given poor demographics and historically high debt loads, I think one would have to assume this "reflation" is just a counter-trend mean reversion like 2017-2018 and not the beginning of a new secular trend. And until the Fed (inevitably) starts doing direct debt monetization (MMT), which likely doesn't happen until we hit that 0 bound and real interest rates start going up (and all the pain that will cause starts to be felt) I don't really think it likely that the secular stock bull market is over (and why I also don't think the new secular bull market in gold has even made it passed maybe the 2nd or 3rd inning at most).

One final argument, if the bull was strong enough to not only survive COVID with all the lockdowns and everything.... but strong enough to have this crazy V shaped rally and close the year positive, why on earth would it just suddenly just keel over and die now? The bull is still too strong. It's got much further to run before it's going to be ready to give up the ghost. Corrections of course will happen along the way, and now would be a good healthy time to have a correction. But valuation be damned, the bull has much further to go.

[pmward]

Thank you for the great response.

I think this is where the digital currency comes in because if governments can enforce negative interest rates without people hoarding cash then it provides the more flexibility in policy making. I do not think we can go back down to close to zero without going negative next time.

The question is will they loosen monetary policy faster than the next deflationary wave in anticipation of digital currencies being ushered in, will digital currencies be the result of the next deflationary wave, or will digital currencies be in place before the next deflationary wave.

While I think some kind of FedCoin is obviously inevitable, I don't necessarily think it will be to force negative interest rates. I think it will more be a tool used to help enable direct monetization (MMT). I currently do not expect the Fed will allow rates to go negative here. I think that once the curve goes basically flat at 0 and the deflation continues, it's going to create a lot of pain (like 2008 levels of pain). Instead of going negative, I think they go the route of direct monetization of some form. This direct monetization is the thing that would actually bring inflation back. Basically, they will reach a point that they will be willing to do whatever it takes to get inflation going again. Once they actually get inflation going again, they will implement yield curve control to inflate away the debt. Basically, it will be a 1940s situation all over again only using a more modern approach. Think for a moment on this, what happens to gold in a year we have a 10% burst of inflation and say bond yields capped at 2%? This is why I say gold is likely only in the 2nd or maybe 3rd inning of its cyclical bull market at most. But there is room for a pretty potent cyclical gold bear market there during the initial period the yield curve does hit the 0 bound before the direct monetization comes into play.

Once the debt burden is inflated away, then the biggest deflationary force is basically gone. Not to mention that by this time our demographics will be in a better spot. This probably doesn't play out over the next year or two, more like the next decade or more. But look what happened in the 50s and 60s after the debt was inflated away in the 40s. That was a great period of prosperity. The nominal debt payments were no longer sucking away the economic growth.