Tuesday, July 28, 2009

It Ain’t That Simple

15 times $70 = 1050
1050 minus 10% = 945

This is the fair value math for the S&P 500. An appropriate P/E times a believable operating earnings number (12 months forward – mid 2010) minus an appropriate discount rate (stocks are, after all, a discounting mechanism). Of course, one can debate the inputs and the appropriate discounting time period, but the methodology is flawless.

Embedded in the methodology are elements that should (but often don't) go beyond simple business cycle, industry, and company analysis. Factors such as:

• A new world economic order
• A new financial services business model
• The appropriate amount of government intervention

Factors that I will discuss at next Tuesday’s New York Society of Security Analysts “Market Forecast” luncheon.

Unfortunately, these macro factors are not part of most investors’ toolkits. Beyond how such macro factors will impact the shape of the business cycle, big think subjects (such as, What economic philosophy will be the guiding force now that laissez-faire/cowboy capitalism is no longer the dominant principle?) have no way of being incorporated in your standard research methodology. Beyond the subjective aspects of such information, it is difficult to impossible for many investors to fit a new world economic order, for example, into your standard discounted cash flow model. Put differently, there’s no CAPM for the obvious yet out of the box factors that move economies and markets. Yet, they do matter.

Investment Strategy Implications

By all accounts, stocks are more than fully valued. Only those with the rosiest of glasses can envision earnings and P/Es greater than those listed above. Then again, a return of animal spirits overriding the highly uncertain transitional macro elements noted above is not out of the question – especially with $3.5 trillion* still sitting in near zero percent money market funds.

*A hefty 41% of the market value of the S&P 500

1 comment:

Mom said...

I just read your article "Dabbling in the Dark Art of Chart-Pattern Reading" and, although I have been a chartist for over 11 years, I can understand your trepidation on relying on charts to follow the market.

Over the last 11 years I have prodded and poked holes in every indicator imaginable to mankind mostly to no avail. However, there was one indicator that stood the test of time and started to "talk" to me, the MACD. So for the last 5 years or so I have pared my technical analysis down to only the MACD. Price and MACD is all I use and all I need.

Then I will only make trading decisions based on MACD divergences. So to make a long story short, I know my MACD divergences, trust me.

A bearish divergence took place in early June when the SPX made a new swing high but the MACD didn't, it made a lower high - that is a bearish divergence. It just so happened that the momentum indicator of which you mentioned made a bearish divergence as well.

As for what is happening currently there is no divergence bearish or bullish in either the MACD or momentum. Sure momentum is falling as the market is moving sideways but that is not a divergence that is just the indicator doing what it does and as matter of fact if the MACD were falling as well that is actually bullish.

To see a divergence you need to compare the current high or low to the last high or low of both the market and the indicator. If the market is making a new high or low but the MACD is not then you have a divergence.