Q1 Market Update: The Stock Market is Now Overvalued

Since the market bottom in March, I have been rationalizing the rally in equities by observing that the market seemed to be honing in on a target return on the S&P 500 of about 7%. What was changing over time was the market's view of long term inflation. Projected equity returns are calculated as the opening dividend yield (with the dividend based on the historical payout ratio on next year's trend earnings) plus the long term growth rate of inflation-adjusted trend earnings times the long term rate of inflation. As market prices have risen, the dividend yield has fallen, but the projected rate of inflation has risen. In 2010, however, the yield has continued to fall while the market's assumption for inflation has not risen commensurately.

Right now (April 16, 2010) the S&P 500 is pricing in a 6.6% return.

Such a low return is hard to justify. I can make the argument that 6.8% is a reasonable return (assumes a 4.5% equity risk premium over the equilibrium 30-year TIPS rate). Even a 6.8% return is much lower than the long term return that most market participants assume to be 8-10%.

The trend earnings being used in my calculation is $59.22, which approximates the projected 2010 as-reported earnings (as projected by Standard and Poor's analysts on a top-down basis) of $62.09.

In addition, I continue to believe that the market's assumption for long-term inflation of 2.7% is high. I view the equilibrium inflation rate to be 2.25% (the Fed's target), and feel that given the high debt levels in our economy we face more risk from deflation than from inflation. (I realize that this is not a very popular view, and that most people feel the opposite.)

If we look at the rates on fixed income investments, it appears that the long end of the yield curve holds the most value, for Treasury Bonds, Municipal Bonds and Investment Grade Corporate Bonds. (High yield bonds and TIPS, on the other hand, are overvalued.) Long bonds are not undervalued, necessarily, but deserve at least a target weighting in a portfolio.

I do believe that the stock market is likely to keep rising in the near term as the economy and earnings expand. It should be noted, however, that investors are now playing with the house's money, and that in the next recession stocks are likely to at least revisit the current levels, if not go below them.

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