Is the value of corporate America, as measured by the S&P 500, undervalued? This is "the question" pretty much all of the time, so let's look at The Wealth Strategies version of the answer.
Every month I update The Seven Signs of a Changing Economy. Sign #6 is the S&P 500 earnings per share (EPS). To be most fair in the earnings estimate we use an average of the estimated earnings reported by several research firms. This estimate is plugged into a business school "rule of thumb" calculation that is quick and easy, THE RULE OF 20.
The Rule Of 20 also takes into account the rate of inflation. The rate of inflation can be difficult to measure, as I have written about in prior blogs. The reason is that the BLS inflation data EXCLUDES food and energy, but does INCLUDE housing with a 40% weighting. Of course food and energy costs are up a lot and housing is down a lot, which skews the inflation number down a lot. So, we do what all smart people do, we make a reasonable guesstimate! Our guess is the inflation rate is 6%.
Here is The Rule Of 20 Fair Market Valuation: you take 20 and subtract the inflation rate of 6% which equals 14. This becomes the multiplier. Thus, you would take 14 X the earnings per share estimate for 2012 of $105.00. 14 X $105.00 = S&P 500 Fair Market Value of 1,470, well above today's close of 1,158.67.
On the surface the S&P 500 appears undervalued. The problem is this.......our economy is slowing again. Growth was adjusted down this week from 2.5% to 2.00%, no big deal, just a 20% reduction off of an already poor growth number. Thus, actual earnings could come in at say $85.00 per share. In addition, investors may become risk averse and be willing to pay only 10 X earnings not the 14X implied by The Rule Of 20. All of a sudden Fair Market Value of the S&P 500 becomes 850, well below today's close of 1,158.67!
The point is this: the value of Corporate America is extremelyy sensitive to both earnings and risk. At this time risk tolerance is fading and earnings could be close behind. Like many others I do think we could see a year end rally here. My concern is that it will be a "suckers rally" and the next sell-off could be to surprisingly lower levels. It is time to be wide awake with your investment positions!!
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