As Clusterstock readers know, there are a few folks whose long-term valuation analyses make good sense to us: those who use “cyclically-adjusted” profit margins and long-term average PEs (Jeremy Grantham, John Hussman, Andrew Smithers, Robert Shiller, etc). One of the more bullish of these folks, John Hussman, puts fair value on the S&P 500 at 1000-1100. This is considerably higher than Smithers and Shiller (850-900ish), but it implies that stocks are now more than 25% undervalued.
More importantly, Hussman’s analysis suggests that the S&P’s current level, 780, puts today’s valuations in the lowest 20% of historical valuations. If one thing has proven true again and again throughout market history, it is that long-term returns for low-priced markets tend to be high and returns for high-priced markets tend to be low.
John’s not calling the bottom, and neither are we. But the more stocks fall, the more comfortable we get about adding money to stocks, and the more excited we get about the likely long-term returns.
Even if the U.S. economy experiences a much deeper recession, I believe that the 1000-1100 level on the S&P represents a reasonable estimate of “fair value” for the S&P 500. That estimate is somewhat conservative since I am adjusting for the fact that earnings in recent years have been based on very wide profit margins, but could be too conservative given that long-term interest rates are very low. Long-duration instruments like stocks should not be priced off of short-duration instruments like 10-year Treasury bonds, or even 30-year Treasuries, so low interest rates shouldn’t make investors recklessly optimistic about their valuation estimates. In any event, I do believe that current levels represent value from the standpoint of long-term investment prospects.
As for extreme and less likely benchmarks, the 780 level on the S&P 500 would represent a 50% loss from the market’s peak, and would put the market in the lowest 20% of all historical valuations. I would expect heavy demand from value-conscious investors about that level if the market were to decline further, and a decline below that level could be expected to reverse back toward 780 fairly quickly.
Further down, but very unlikely at this point from my perspective, the 700 level on the S&P 500 would represent the lowest 10% of historical valuations, 625 would put the market in the lowest 5% of valuations, and anywhere at 600 or below would put the market in the lowest 1% of historical valuations. I don’t expect to see such a level, but there it is.
Note that these estimates are unaffected by how low earnings might go next quarter or next year. Stocks are not a claim on next quarter’s or next year’s earnings – they are a claim on an indefinite stream of future cash flows.
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