How to Value the Stock Market

The S&P 500 is on the undervalued side and has significant room for growth.

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Tim MicKey
In a headline-driven environment, it's easy to get confused about which way the market is moving. Let's put aside the calamities of the day and focus on the fundamentals of "the market," as defined by the Standard and Poor's 500 Index (S&P 500). The S&P 500, which includes the 500 largest companies in the U.S., represents more than 80 percent of the U.S. stock market and is widely regarded as the best single gauge of the U.S. stock market.

Two powerful measurements for determining stock valuations are price-to-earnings ratio (P/E) and earnings yield (E/P). In fact, earnings and earnings estimates have more to do with the movement of stock prices than any other measure. In 2010, the earnings for the S&P 500 came in at $83.77. According to Standard & Poor's, the earnings estimates for 2011 are at $97.81 and $111.73 for 2012. Both are at historic highs and have been revised upwards in the past six months. Assuming that these estimates hold, we can use this data to compare our current findings against historical results.

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The P/E ratios of the S&P 500 from 1988 to today range from a high of 29.44 in the fourth quarter of 2001 to a low of 11.51 posted in the fourth quarter of 1988. Eliminate the extremes, and you come away with averages that fall between 13x and 16x earnings. As of July 1, 2011, the S&P 500's current P/E is 13.65 (using the S&P 500 July 1 price of 1335 and a 2011 earnings estimate of $97.81). If you use the 2012 earnings estimate, you end up at 11.95x earnings. As you can see, we are much closer to the historical low end than the high end whether we use the 2011 or 2012 estimates—which indicates that the markets are on the undervalued side and have significant room for growth.

Now, let's take a look at earnings yield, which is defined as earnings/price. If we use the same 2011 S&P 500 earnings estimate of $97.81 and an S&P price of 1335 (97.81/1335), you come away with a multiple of .073 or 7.3 percent. Simply put, this means that the expected earnings of the S&P 500 are 7.3 percent of the price of the index. Why is this relevant? Because we are comparing the additional rate of return we expect to receive by investing in equities with the anticipated rate of return offered by other asset classes.

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We can also compare these returns to the rate of inflation. Over the past 50 years, the average earnings yield for the S&P 500 has outpaced inflation by 2.4 percent. When the market is above that mark, equities are generally considered attractive. When below that mark, stocks may be considered expensive. If we subtract the current core inflation rate of 1.5 percent from the 2011 S&P 500 earnings estimate of 7.3 percent, we end up with 5.8 percent—well above the 50-year 2.4 percent level. Even if we use the 3.4 percent consumer price index rate, we come out at 3.9 percent (7.3 percent minus 3.4 percent), which is still a very attractive number when compared to most interest-bearing investments. A look at history shows that the last time the S&P 500 earnings yield approached 7 percent was at the end of 1994. The market enjoyed a nice five-year run from there. While it's not the perfect indicator, when combined with the P/E ratio, earnings yield can provide a useful point of reference.

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Earnings and earnings estimates play an important role in market dynamics. We just finished the second quarter and will soon find out how just how solid those estimates are. If the companies hit their earnings targets that's good news, but more important is the guidance they give for the future. The markets will put more emphasis on future earnings expectations than how well they did last quarter. That's history.

Timothy S. MicKey , CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall , on Twitter at @MonumentWealth and @TimothySMickey, and on their Facebook page. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Strategies involving asset allocation and diversification do not ensure a profit or protect against a loss.