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Stocks Priced Above Fair Value

Stock prices, as expressed by the S&P 500, remain above fair value, which our model pegs at closer to 3200 due to the expected earnings decline in 2020. Our stock-market valuation model takes into account factors such as stock prices, five-year normalized earnings (three historical years, two forward-looking), GDP, inflation, and T-bond and T-bill yields. We note that stocks rarely trade right at fair value. Since 1960, on average, the index has traded at a tight 2% above fair value, but the standard deviation to the mean is 16%. As such, we normally expect the S&P 500 to trade between 14% undervalued and 18% overvalued. At current prices, the stock market is almost 20% above fair value, implying that investors are quite optimistic about equities in the coming months. We'd feel better about the outlook for stocks if valuations were not so stretched. Several factors could improve valuations: a pullback in stock prices; lower bond yields; or better earnings, as the current 4Q EPS reporting season is expected to be the final negative comparison year over year related to the pandemic. ...  deviation to the mean is 16%. As such, we normally expect the S&P 500 to trade between 14% undervalued and 18% overvalued. At current prices, the stock market is almost 20% above fair value, implying that investors are quite optimistic about equities in the coming months. We'd feel better about the outlook for stocks if valuations were not so stretched. Several factors could improve valuations: a pullback in stock prices; lower bond yields; or better earnings, as the current 4Q EPS reporting season is expected to be the final negative comparison year over year related to the pandemic.   more

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