How to value the stock market

I’m still on summer vacation, but figured I’d post an analysis I did earlier this month on how to value the stock market relative to bond rates.  While some of the prices may have changed a bit, the point is for this to be a long term analytical framework.  I welcome comments challenging or adding to the theory, as I’m always searching for the right answers…


From 1926 to 2001, stocks, bonds and t-bills produced the following returns:



Real After-tax

















Source: Ibbotson Associates

It is from Ibbotson’s older studies that market participants have settled in on an equity risk premium of 5-6%. This analysis would imply an equity risk premium of as high as 7%. Since the market has basically moved sideways since 2001, with relatively low dividends and a rally in bonds, I would suspect that a more recent run of Ibbotson’s analysis would have the spread come down to around the historical average of 5-6%.

The purpose of this paper is not to determine whether 5-6% is the right number. Instead I am seeking to provide a method of calculating what the priced-in return of the market is today, and then to use a "disequilibrium analysis" to determine how the market may have it wrong.


On a basic level, equity returns are driven by two things: the beginning dividend yield and the long term growth rate of dividends.

Using the Gordon growth model


Where P= stock price, D=dividend, r= expected rate of return and g=dividend growth rate

Rearranged to

D/P + g = r

So that the dividend yield plus the long term dividend growth rate equals the expected rate of return.

Dividend yield and payout ratio. Ok, easy enough. The problem with the dividend yield is that the payout ratio has fluctuated over time, due both to changes in management optimism and to changes in the tax code and options compensation that encourage stock buybacks. Stock buybacks are a form of dividend in that they are not reinvested in the business.

Dividend growth. We will focus on the market as a whole to determine the general valuation level of the market. Over the long term corporate profits will grow in line with Nominal GDP. There are some periods when profits’ share of GDP goes up, like the late 1990s and 2000s, and period when it goes down, like the 1970s and early 1980s, but over the long term they will grow in line with GDP. S&P 500 profits, however, grow at a rate that is about 1% slower than GDP, as that index consists of larger, more mature companies.

GDP Growth. Nominal GDP growth consists of three components: growth in the workforce, growth in worker productivity and inflation. Long term real GDP growth has traditionally been 2.5% to 3%, with workforce growth at about 1% and productivity at 1.5% to 2%. Workforce growth has slowed recently and will likely move toward 0% for a while as the baby boomers retire, and then pick back up to its historical pace in the latter part of next decade. Productivity growth, on the other hand, has been running above trend recently.

Real earnings growth. If I strip out inflation, real S&P earnings have grown at a rate of 1.74% a year since 1960, which makes sense relative to real GDP growth of 2.5-3.0%.

Inflation. Inflation has been volatile since the 1920s. It was negative in the 1930s, regulated and then high in the 1940s, moderate in the 1950s, rising in the 1960s, very high in the 1970s, falling then rising in the 1980s, stable in the 1990s, and rising in the 2000s. As of August 7, 2008, the 30-year treasury bond was yielding 4.55% and the 30-year TIPS (Treasury Inflation Protected Security) was yielding 2.05%, meaning the market expects long term inflation of 2.5%.

Below I plot out today’s yield curve relative to my "equilibrium" yield curve. As interest rates, earnings and inflation are volatile, yet mean-reverting, I need to anchor the values in reasonable, long term assumptions.

Current vs. Equilibrium Yield Curves

Fed Funds




August 7, 2008









Assumed Inflation




Equilibrium Treasuries:











Source: PIMCO, author’s analysis

Trend real earnings. To determine whether today’s market is over- or under-valued, I calculated long term real trend earnings for the S&P. I use inflation-adjusted trend earnings to smooth out the effect of business and inflation cycles. A graph of annual S&P real earnings is shown below.

Source: Damodoran, S&P, author’s calculations

Trend earnings for 2008 are estimated to be $58.65. The S&P is currently trading at 1,266.07, which results in a PE to trend earnings of 21.6. The long term average payout ratio of S&P companies is 50%, so the implied dividend yield to trend is about 2.3%, which is about what the actual dividend yield is today, if we include stock buybacks. Focusing on dividend yield is a better way to value the market than focusing on current year PEs, because dividends are far less volatile than earnings. Corporate managers tend to only pay dividends relative to their long term earnings power, because they don’t like to have to cut dividends at a later date.

Expected S&P Return. We now have all of the pieces to calculate what return is priced into today’s S&P.

Dividend yield


Real trend earnings growth


Real return




Total return


Tax Rate


After Tax return


Fixed Income Alternatives. No compare this to current fixed income alternatives.



After tax (40%)


(pre tax)

Vanguard Long Term Investment Grade




Vanguard Long Term Treasury




Vanguard Short Term Treasury




The equity risk premium is currently only 3.56% relative to the equilibrium risk-free rate. The best deal looks like investing in long term investment grade bonds, particularly if you own them in a tax deferred account. On an after-tax basis, the spread is 3.72%.

Disequilibrium Analysis. Looking at the above numbers, one could make the argument that the assumed inflation rate is below the long term trend of 3.0%. If inflation was 0.5% higher, that would accrue to stock returns (to 7%) and eat in to real bond returns. Either way, it appears the spread between stock returns and investment grade bond returns is too low. Treasury rates are either in line with, or slightly below equilibrium. Real earnings growth has more risk of surprising to the down side after the big rise over the past two decades. Taxes are likely to rise near term, with the difference between taxes on equities and bonds narrowing.

Tax-free alternatives. The above after tax rates should be compared to municipal bonds when investing in taxable accounts. The equilibrium rates are compared to treasuries on an after-tax basis. You would probably want to add a few basis points to compensate for the fact that muni bonds carry a little more risk than treasuries. And to make sure that the equilibrium rate is at least above inflation.

Tax Free Alternatives


After tax (5%)


(pre tax vs. Treasuries)

Vanguard Long Term Tax Free




Vanguard Int. Term Tax Free




Vanguard Short Term Tax Free




Here I’m assuming you are not investing in triple tax-free bonds and are paying state tax of 5%. It would appear that municipal bonds offer terrific value on an after-tax basis and are well above their equilibrium yields and are even above investment grade corporates on an after-tax basis. In addition, with tax rates more likely to rise than fall, the attractiveness of muni bonds only increases.

Sadly, it’s tough to beat inflation on an after tax basis by investing in bonds. The key is to hold bonds in your tax deferred accounts and stocks and muni bonds in your taxable accounts. I know it sounds counter-intuitive to put fixed income in your long term retirement accounts, but if you run the math, you’ll save a lot on taxes versus holding taxable bonds in a taxable account and stocks in a tax deferred account.

S&P Values at different Expected Returns. I personally believe that the current earnings yield is too low and that the stock market is overvalued. The reason the long term return of the market is 8-10% is that in starting point year 1926 the dividend yield was higher than 5%, which together with 3% inflation and 2% real earnings growth gives you a 10% return. The great returns in the market since that time have come from multiple expansion, aka yield compression. With the implied dividend yield of only 2.5% today, the potential for continued multiple expansion is diminished, and the potential for multiple contraction (a process that has been playing out since 2000, by the way) is increased.

Here is how the S&P would need to be valued to provide a range of expected returns.

                                    Source: author’s calculations

In other words, to target a long term 8% return that provides a 5% equity risk premium to the average risk-free rate, the market would need to fall 38% from today’s levels. If long term inflation ends up being 3% instead of the 2.5% that the treasury market predicts, then the market only needs to fall 29%.

Buy bonds.

New York tax revenues go “poof”

Due to large losses at financial firms in the past two years, New York City and State face a huge revenue shortfall as banks stop paying taxes and in many cases are filing for refunds, Bloomberg News reports.  Many large institutions will be able to carry forward their losses to offset cash taxes for 5 or 6 years.  We are starting to see just how geared the New York tax base is to the fortunes Wall Street firms and their employees.  This is particularly tough given how geared the earnings of those insitutions are in the first place.

If, as I believe, Wall Street is about to go through a permanant downsizing and restructuring, New York will be in for a long reckoning indeed.  As someone of the generally anti-tax persuasion, I hope New York is able to navigate this crisis by downsizing and restructuring its preposterously bloated government bureaucracy.  Alas, knowing New York’s politics and history, I suspect it will be the private citizenry that will end up getting milked instead.

UBS to jettison its investment bank?

UBS has decided to separate its investment bank from its asset management arm.  This step could presage UBS’ jettisoning of its investment bank.  As I said in a previous post, Merrill Lynch should do the same thing.  Apparently 247WallStreet agrees with me and throws in Citibank and Wachovia to boot.

Asset management is in inherent conflict with investment banking in that an asset management client can never be sure that he isn’t being put into an investment because its the right investment for his portfolo or because it makes money for the investment bank.  The whole auction rate security debacle is case in point.  So is the collapse and bailout of the internal Bear Stearns, Citigroup and UBS hedge funds, and the near death of Goldman’s Global Alpha hedge fund.

An investor is better off trusting a pure-play asset manager (like say a Northern Trust) than an investment bank or universal bank.

My advice to John Thain (not that he asked)

I’m not a management consultant, nor do I play one on TV.  I have worked in and around Wall Street for a little while, however.  That makes me not surprised to see a chart like this one, courtesy of the WSJ yesterday.


While I don’t have the exact numbers, if you ask me it looks like Merrill Lynch will write off in two years nearly a decades’ worth of earnings.  I haven’t gone through the balance sheet, but I would hazard an educated guess that virtually all of those losses are tied to the fact that Merrill has operated as a giant, yet conflicted, credit hedge fund for the past five years.  Conflicted in that as an underwriter and promoter of structured securities, it can’t suddenly switch and turn bearish like actual hedge funds.

As an outside director I would ask why Merrill Lynch was in that business in the first place.  Merrill’s great asset is its nationwide network of stockbrokers and its reputation as an asset manager.  Asset managers trade at higher multiples than investment banks for a good reason.  Money managers deliver in nice annuity stream of fee income, while investment banking is so volatile that…you can wipe out a decade’s worth of earnings in two years.

For big banks, investment banking is like the movie business.  It is the glamorous world of high finance drawing bank CEOs like bugs to a flame.  Like investing in the movie business, the bank’s investors are last in line behind all of the star investment bankers who take something like 2/3 of the revenue, even in the good years.

The problem is that the profitability of old fashioned investment banking, brokerage and sales and trading services has gone down over the past decade, which explains why all the investment banks increased their leverage and entered the more exotic world of structured finance.  Without all the leverage, however, the profitability comes down.

As I have been saying over and over, the capacity in the financial services industry in general, and investment banking in particular, needs to shrink to reflect the new reality of reduced profitability and leverage. (With the goal of evenutally increasing profitability, of course.)

So my advice to the Merrill Lynch CEO John Thain would be thus: focus on asset managment.  That is Merrill’s great asset.  Investment banking and structured finance have dragged down your multiple and caused massive dilution to your shareholders.  Lehman Brothers needs to be a credit hedge fund to justify its existence.  You don’t.  You actually have something valuable, a brand that resonates with retail investors.  Focus on that and leave investment banking to the suckers.

Random thoughts and links on the dollar, credit, brainwaves, income inequality and Comcast

Catching up on my reading I came across some interesting tidbits, which are shared below.

The Economist has published its Big Mac index of Purchasing Power Parity, and to no surprise, it shows the European currencies as massively overvalued and the Asian currencies as massively undervalued, with the dollar, on average, just about right.

In the same issue, the Economist notes that the seemingly large rise in the inequality of real incomes in the US is likely overstated, as the rich have experienced much more inflation in the things they buy than the middle class have experienced in the things they buy over the past twenty years.  This largely explains why the issue hasn’t gotten much grab politically.  Interestingly, the trend has changed recently with the rise in commodity and import prices greatly impacting the middle class, thus their generally foul mood on the economy over the past several years.  Both parties don’t get it: INFLATION is the biggest political issue, more specifically than the economy, which is borne out in polls that break out people’s ranking of top issues.  They consistently rank gas prices, food prices and health care prices as the top three economic issues.  Note that’s health care PRICES, not ACCESS.

In this Business Week article, Charles Morris, author of the excellent book Trillion Dollar Meltdown, outlines his assessment and prescription for the credit crisis.  As usual, he is spot on.

In the most recent Business Week, they review a new product that allows you to control your computer by only using your brain.  Behold the future.

In this week’s Barrons, Michael Santoli posits that perhaps the big capitulation everyone in the markets are waiting for may not happen, instead we all may suffer a slow-motion drift sideways-and-down that may lead market participants to drift away out of boredom. I agree.

"Ultimately, the trajectory of the market, amid only equivocal signs that it’s trying to bottom, might hinge on whether investors finally make it all the way to the opposite of love, which the old saying tells us is not hate but indifference. It’s hard to argue we’re quite there. So many folks have been sitting in vigil for solid evidence of a climactic panic selloff and recovery (guilty as charged here) that maybe a sort of slow-motion give-up phase will be the crowd-humbling scenario that plays out instead."

Also in this week’s Barrons, Eric Savitz reminds us, contrary to current market sentiment, how badly the cable companies are kicking the phone companies’ behinds in all things delivered by a wire.  Not that it makes me feel better about the losses I’ve taken since buying Comcast stock in September 2007.