Sunday, December 20, 2009

S&P 500 Valuations and Stock Prices

The total market capitalization of the S&P 500 is about $13.5 T. Per Zero Hedge and CapIQ, total shareholder equity of the companies in the index is $4.8 T. Goodwill is $1.6 T. These are high ratios historically. In addition, the dividend yield is slightly under 2%.

Click HERE for a list of dividend yields on the S&P 500 index going back to the 1800s (synthetic index for long-ago years, I believe).

Note the high yields from the 1930s well into the 1950s. It was that era that really provided the upside to stock returns vs. bonds. If one looks at the 1970s and then especially the early 1980s, it is easy to demonstrate that an investment in zero coupon 30-year Treasuries in 1982 did just as well as the stock market with less volatility and fewer ongoing costs. Depending on the exact interest rate at the time, a long-term Treasury bought when inflation was raging but Mr. Volcker had tightened money severely was only a few dollars, destined to turn in a few years (2012 if bought in 1982) into one hundred dollars.

Conclusion: The above is a simple way to look at stock valuations including comparative valuations during times of very low Federal debt interest rates. The results are consistent with Andrew Smithers' analysis and that of Jeremy Grantham.

The Smithers analysis is that the stock market is almost 50% overvalued. This would imply that fair value for the S&P 500 index is not much about 700. Given that the averages spend as much time below fair value as above it, and given that even a rising dividend payout stream could be consistent with a 50% decline in stock prices to allow (say) a 5% dividend yield for the index, my conclusion is that there is substantial downside risk in stock prices, even under a decent scenario for economic performance.

The above analysis recognizes that all financial assets are correlated. In retrospect we look back at post-War World II low stock valuations and low Treasury yields and see the value in stocks, but in those days, the general worry was that a deflationary Depression would return. Now the worry is that an inflationary period will return; but there is no high-yielding secure government debt to flee to as there was in the 1980s. All is at risk. In this environment, Ginnie Maes, which pay back principal as well as pay interest, may be the best investment for a substantial chunk of retirement money.

Copyright (C) Long Lake LLC 2009

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