Wednesday, October 24, 2007

The Hidden Value in Valuation Models: The Message of Mr. Market

"I think therefore I predict."

This is the motto of all investment strategists. And rightly so for what other purpose does an investment strategist serve than to analyze then predict? There is, however (you knew there was an however coming), a complementary role that an investment strategist serves which is to assess the valuation calls made by Mr. Market expressed in the form of an expected return. Accordingly, using the simple yet very effective Modified Fed Model above (click on table for larger image) we can explore some of the predictive elements of Mr. Market.

As of yesterday’s close, the inputs for equities (S&P 500) and interest rates (10 year US Treasury) are 1520 and 4.41%. Operating earnings estimates for the S&P 500 for 2007 are right around $92. Now, if operating earnings for S&P 500 for 2007 come in around $92, full value for the S&P 500 is somewhere between around 1700 and 1766. That interprets into a 12 to 16% gain from current levels. Not bad for just over 2 months! However, as tantalizing as an average of 14% for 2 months (84% annualized) might be, it is more reasonable to assume that Mr. Market has some other time frame and set of inputs in mind.

Let’s say Mr. Market is a good student of market history. Therefore, he is looking beyond the next 2 months and well into 2008. Perhaps he is looking as far ahead as the next twelve months, give or take. Under those circumstances, Mr. Market seems to be gravitating more toward a more traditional annual rate of return, something closer to the long-term return on large cap equities of 12%.

In that case, to produce a 12% return Mr. Market seems to be calling for one of several scenarios to unfold. In one assumption, rates and operating earnings rise by ½ % and 4.3%, respectively. In another, rates remain unchanged while earnings slump 4.3% from $92 to $88*. (Both are highlighted in the boxed areas of the yellow shaded zone.) Or perhaps both rates and earnings remain unchanged (boxed returns noted above).

Investment Strategy Implications

The question an investor needs to answer is “What are the probabilities of certain earnings and interest rate scenarios given specific inputs?”

All investment strategists have their views. We pontificate on them with great regularity. Nevertheless, it is incumbent upon every investment strategist and investor to attempt to understand just what Mr. Market is saying in the form of scenarios based on rates of return, be it this valuation model or some other that has a comparable track record.

At present, Mr. Market is in a fairly narrow zone of probable outcomes. That will no doubt change as the multi faceted aspects of the valuation inputs evolve over the coming months and year ahead. Then again there is the possibility that Mr. Market is way off the mark and rates and/or earnings move dramatically away from the narrow zone currently forecasted.

Getting that call right generates the alpha all investors fervently desire, something Mr. Market just cannot help provide. What's your call?

*Of course, a third option exists – the model is all wrong. The inputs are too high, too low, or just plain irrelevant. While this may be the case, the fact that the inputs and the adjustments made (raising the capitalization factor, the 10 year Treasure rate, by 80 to 100 basis points) are derived from actual experience over the life of the current bull market suggests that there is some validity in its methodology.

No comments: