How to predict the future – on the back of an envelope!

Fortune telling isn’t as difficult as you might think. A good prognosticor will combine some highly probable occurances (“you will meet someone”) with some razzle dazzle (“and become romantically involved”).

Forecasting the stock market is easy enough as well. A couple of metrics will provide the most likely possibilities, but to sell it requires building a complex set of equations and fancy charts for marketing purposes – that of course would arrive at the very same answer.

I am not inclined to predict items to 5 decimal places, especially when there are billions of factors that will introduce errors, so let’s keep it simple.  The estimated forward earnings yield on the S&P 500 is roughly 8.75%, which means at current levels the earnings (for companies in the index) is $110 on the roughly 1250 level of the index.  I know a little bit of math, so my feeble mind would interpret the status quo in terms of expectations as follows:

If the companies comprising the S&P 500 were to earn $110 in perpetuity (forever) then 1250-ish is a fair valuation (I will not get into re-investment rate mumbo jumbo that might confuse me and Joe the Plumber).

Method 1) But is an 8.75% earnings yield appropriate?  What if 4% – the current long bond yield plus a 2% inflation premium – were more appropriate, given that there are many who expect a low inflation rate is here to stay?  Then the $110 forever would be worth 2750.  WOW!  Lots of upside from 1250 (120%) if suddenly this were true.

Method 2)  Many analysts still use the Price-to-Book Ratio; or how much are you paying for those assets on the books?  Right now the index is valued at about 2X the book value (an accounting measure, don’t worry too much about it).  As more and more of the economy became service oriented, a case could be made for a higher price-to-book valuation.  Assuming the current valuation is biased downward due to the fallout from the financial crisis and an irrational aversion to anything at all risky by investors, why not expect a more normalized 3X book as things settle down.  The index book value (half the current index value) must be something like 625, so the S&P 500 could get back to 3X that number or 1875 – which would mean upside of a not shabby +50%.

Okay, enough about upside; what about the downside?  Suppose the earnings yield on the S&P 500 should be 10%? For the life of me I can’t figure out why it should ever be this high, but it would suggest that the index level could easily be (roughly) 1100, or 12% below its current level.

CONFUSED?  My back-of-the-envelope analysis (no less accurate than any other self-proclaimed soothsayer’s modelling) predicts the S&P 500 could go down 10% to 15%, or could go up 50% to 120% if and when level heads prevail.  Not bad odds if you ask me.  Most likely? The stock market will surprise everyone with a return in the neighborhood of 50% from current levels sooner rather than later.  Any higher than that will be because instead of earnings remaining at a constant level, S&P 500 earnings will keep recovering from their depressed recessionary levels – hardly a stretch of the imagination.

Now wasn’t that fun?  Now watch this classic sesame street clip and tell me it doesn’t depict how Wall Street works!

Riding Portrait

Invest to Live, Live to Ride

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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