Fair Market Value Update

 | Feb 26, 2014 | 12:30 PM EST  | Comments
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"We believe that short-term forecasts of stock or bond prices are useless. The forecasts may tell you a great deal about the forecaster; they tell you nothing about the future."

-- Warren Buffett's letter to Berkshire Hathaway (BRK.A/BRK.B) shareholders, 1980

Forecasting prospective market levels out 12 months is an imprecise art form that requires probabilistic decision making, using imperfect information about an inherently unknowable future.

Forecasting market levels out beyond 12 months is, to me, more a function of one's philosophy than an investment prediction.

But try we must (especially over the next 12 months) even despite The Oracle's protestations.

It has been nearly four months since I last published my estimate of the S&P 500's fair market value, but I am going to give it a go again this morning.

Remembering the phrase that if you have to forecast, forecast often, I will attempt to update my fair market value every month or so in 2014 or as circumstances change.

Late last year, I expressed the view that a domestic economy incapable of reaching escape velocity would produce a challenging earnings landscape. This, to me, represents the continued threat and principal enemy to the U.S. stock market for 2014 and forms the basis for my four core scenarios (economic, earnings and market valuation) that has yielded my fair market value calculation.

Anemic top- and bottom-line growth in corporate sales and profits were by no means the only factors that contributed to my valuation concerns this year -- others include the growing evidence that aggressive monetary policy is losing its effectiveness and that our leaders are failing to address our deep-seated fiscal issues. Instead (and out of necessity), our authorities placed ever more pressure on our monetary policymakers to bear the responsibility of bringing our domestic economy out of its doldrums.

After nearly five years, the results barely met a passing grade and uncovered the depth of our structural headwinds that have been ignored for so many years (e.g., disequilibrium in the jobs market, screwflation of the middle class, financial repression (penalizing the savings class), etc.), and once again investors (and the Fed) have overestimated U.S. economic growth and the positive impact of trickle-down economics (through the lifting of asset prices).

Forecasting is the art of saying what will happen and then explaining why it didn't. While my fundamental observations (and headwinds) still seem materially correct, my assumptions for a contraction in P/E multiples were wrong-footed as were my market conclusions and S&P price targets.

Last year, the S&P 500 dramatically eclipsed my calculations of fair market value, owing principally to an expansion in P/E multiples and, to a lesser degree, a better corporate profit performance (25% of the S&P's better rise was due to higher profits, and 75% was due to an expansion in multiples.)

A year ago, my baseline expectation for 2013 S&P profits was $102-$104 a share (the Street was at about $104). Around midyear, I raised my forecast to $106-$108, as did many other forecasters. Estimated 2013 profits -- a number of fourth-quarter earnings have yet to be reported -- are likely to come in slightly higher at about $108.50 a share.

For 2014, the consensus estimates that the S&P 500 will achieve profits of about $116 to $120 a share. (Recently, those projections have been skewing higher and seem to be moving closer to $120 a share.) My base case estimate is for $112-$114 a share, a gain of under 5% (year over year), which is, again, below consensus. Indeed the gap between my projections ($113) and consensus ($120) has rarely been wider.

Slowing sales, a contraction in margins, the reduced influence/benefit from aggressive monetary policy and political uncertainties are some of the reasons why my baseline earnings expectation is for below-consensus 2014 S&P 500 profits.

Today's fair market value calculation of 1650 incorporates the following melded probability distribution of my four scenarios. Since I began this exercise several years ago, I have tried to be consistent with methodology, reasonable in my profit forecasts, and I have applied sensible valuations. Again, I want to emphasize that my methodology, though appearing precise, recognizes the difficulty of attaining investment precision given the numerous moving parts (economic, interest rates, sentiment/psychology, political outcomes and other exogenous factors) in its calculation. It is intended more as a thoughtful guideline (of reasonable expectations/outcomes) than an exercise that should be taken literally. (I strongly recommend that subscribers input their own probabilities and outcomes in order to produce their own market expectations.)

Scenario Analysis

"A good forecaster is not smarter than everyone else; he merely has his ignorance better organized."

-- Anonymous

Below are the criteria and methodology I use to evaluate the S&P 500 and upon which I conclude that fair market value is approximately 1650 (so the S&P is overvalued by about 10% compared to Tuesday's close of 1845):

Scenario No. 1 -- Economic Reacceleration Above Consensus (5% probability): The pace of U.S. economic recovery re-accelerates to above-consensus forecasts (3%-plus 2014 real GDP growth) based on pent-up demand in nondurable spending (cars and autos), rising consumer and business confidence and a sustained period of low interest rates. Corporate profit margins are preserved and even expand slightly. The Fed tapering continues and accelerates. European economic growth rises to above 1% in real terms, and China's growth rate exceeds 7.5%. The disruptive influence of our politicians in Washington, D.C., is diminished and fails to adversely influence business/consumer behavior. The yield on the 10-year U.S. note exceeds 3.5%. S&P 500 profits for 2014 meet $120 a share. P/E multiples average 16.5x, producing a 7% 12-month upside. S&P target 1980.

Scenario No. 2 -- Near-Recession (15% probability): The U.S. enters a near-recession (zero to +1.5% real GDP). The Fed disengages from tapering, but it becomes clear that monetary policy has lost its effectiveness. The eurozone turns back into negative real GDP growth, and the debt crisis renews. China's real GDP falls below +7%. The Democratic and Republican Parties grow more contentious, partisan and unequivocal in position. The sovereign debt crisis in Europe heats up again, contributing to a deepening European recession and a hard landing in China and India. The yield on the 10-year U.S. note dips below 2% again. S&P 500 earnings estimates for 2014 are materially reduced (relative to consensus expectations) to a range between $95 and $100 per share. Stocks, valued at 14x under this outcome, have 26% downside risk over the next 12 months. S&P target 1365.

Scenario No. 3 -- Below-Consensus Economic Growth (50% probability): The U.S. experiences a disappointing +1.5% real GDP growth rate, Europe experiences little recovery (zero to +1.0% real GDP), and China's economic growth modestly disappoints relative to expectations. The Fed announces a plan to extend its QE program and ceases the taper in 2014. The yield on the 10-year U.S. note is held between a range of 2.25% and 2.75%. The S&P 500 consensus profit forecast for 2014 is too high ($110 to $112 per share is expected), as corporations' pricing power is limited and profit margins are pressured more than expected. Stocks, valued at 14.75x under this outcome, have 11% downside risk over the next 12 months. S&P target 1635.

Scenario No. 4 -- Muddle Through (30% probability): The U.S. muddles through, with 2.0% to 3.0% real GDP growth; the European economies post a modest recovery (+1% real GDP); and China's economy grows in line relative to consensus forecasts. The Fed's tapering continues. The yield on the 10-year U.S. note is between 2.75% and 3.25%. S&P 500 profits for 2014 are in the range of $115 to $118 a share as some modest margin slippage occurs. Stocks, valued at 15x under this outcome, are moderately overpriced (by 5%). S&P target 1750.

How Do I Use My Fair Market Value Exercise in Actual Practice?

"He who lives by the crystal ball soon learns to eat ground glass."

-- Edgar R. Fiedler in "The Three Rs' of Economic Forecasting -- Irrational, Irrelevant and Irreverent" (June 1977)

The investment mosaic is a complicated one; it makes the riddle of the Sphinx seem simple by comparison.

Whether one is gazing at charts or incorporating fundamentally based discount models, all too often technical and fundamental analysts proclaim precision of market forecast. Frankly, I view those pronouncements as laughable.

There is no special sauce, fractal or system to beat the market and to forecast its future with consistent accuracy -- if there was, Steve Cohen, Lee Cooperman, George Soros or Paul Tudor Jones would have purchased the recipe.

I use this morning's exercise as a guide to portfolio management. Again, it is certainly not meant to be an exercise in precision, but I have found this calculation, over time, to be a generally good discipline that keeps me honest.

The Market Is About 10% Overvalued

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands.

-- Warren Buffett's letter to Berkshire Hathaway shareholders, 2000

I continue to see the stock market as being moderately overvalued -- the higher we go from here, the line between speculation and investment seems likely to be increasingly blurred.

In the past, I have suggested that in a 5% to 10% overvalued market, a conservative investor should not be more than 50% long, and I still stand behind that.

So, if I believe (as I currently do) that the market is slightly more than 10% overvalued, why have any investments in equities? Why do I have more long ideas on my Best Ideas list than short ideas?

The answer is obvious.

At any given time (regardless of where the market is selling), individual stocks are overvalued and undervalued. This is particularly true today since there is so much uncertainty in fiscal (and monetary) policy, in political/economic outcomes and with regard to business and consumer reaction to policy.

Don't take my word for the fair market value calculation. Again, I strongly encourage you to input your own earnings/economic/multiple expectations and create your own fair market value calculation.

This allows investors and traders to pick sides on the issues and make their bets a bit more intelligently, particularly on the broader market.

I hope you find this exercise to be helpful as a guideline.

Reflecting this exercise in addition to other input, I am currently approximately 10% net short.


This column originally appeared on Real Money Pro at 8:16 a.m. EST on Feb. 26.

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