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The election is behind us, and while the focus now shifts to how the politicians will avoid the fiscal cliff, we thought a quick discussion of the underlying value inherent in U.S. stocks would be helpful.

As we have written before, as the fiscal cliff negotiations drag on, we are liable to see much more volatility in stock values than has been normal.  The negotiations will take strange turns at various times, and there will be no shortage of articles and commentary discussing the worst case scenarios.  We firmly believe that the fiscal cliff will be avoided, and that a recession will not occur.

But let’s put that aside for a moment and just take a look at how stocks and bonds are valued now and how they might be valued in less than optimal conditions. Stocks prices are based on the present value of the profits and dividends that are likely to come from the companies issuing the stock.  Bond prices are based on the present value of the interest payments that are likely to come.

Bonds currently offer very little in the way of income because interest rates remain at historical lows.  Accordingly, we believe the short term total return on bonds will also be quite low.  Stocks, on the other hand, remain cheap and their upside strong because of these same low interest rates.  In drawing this conclusion, we are relying on some great research and analysis conducted by economist Brian Wesbury, as summarized below.

Wesbury’s team calculated the present value of the expected dividends and profits from stocks.  They used a standard approach of dividing existing corporate profits by the current 10-year Treasury yield (1.7%) and then comparing the result with a similar index over the last 60 years.  This method estimates that the fair-value for the Dow would be a ridiculously high 51,500, about four times the current level.

Recognizing that as an absurd valuation, which is the result of using the current artificially low long-term interest rates, Wesbury’s team adjusted the model and assumed that the appropriate 10-year Treasury yield would really be 4.5%.  That may seem arbitrary, but it is actually the same as the Federal Reserve’s long-term estimate.  Using the higher interest rate estimate suggests that the fair value of the Dow today would be 19,750.

With the Dow currently at 12,815 (as of this writing), there would seem to be tremendous upside to the stock market.

But what if the European situation isn’t resolved?  What if the U.S. doesn’t avoid the fiscal cliff?  What would happen to the value of stocks in either situation?  It is impossible to predict exactly what would happen since neither of these events is an all-or-nothing proposition.  What can be done, however, is to “test” the stock market value calculations above, and that’s exactly what Wesbury’s team did.

Wesbury’s team tested what would happen if corporate profits were to drop.  A drop in future profits would mean a drop in future dividends, which would mean a drop in the value of stocks.  To be extra cautious, the analysis team used the higher interest rate assumption.  They concluded that if corporate profits fell 25% from current levels, the fair-value of the Dow would be 15,500.

In their own words, if profits fall roughly 25% from current levels and interest rates almost triple from their current levels, the Wesbury team still calculates that today’s Dow of 12,815 is still undervalued by about 17% even if corporate profits drop by 25%.

This doesn’t mean the stock market is going to rally tomorrow, next week, or next quarter.  As we’ve seen in the last couple of days, the uncertainty about the fiscal cliff issue has depressed stock prices.  Whether or not they bounce back is a function of what the future holds.  The “plough horse” economy we have now justifies the Dow level that we’ve seen over the last several months – somewhere in the 12,000 to 13,500 level.  It would take a pretty steep recession to drive us below that level.

We still put the odds of any recession at about one-in-four.  On the other hand, greater volatility over the next several weeks up to and through year end is almost guaranteed.  The negotiations and brinksmanship will be fierce, but neither is a long-term issue.  We obviously can’t guarantee any projection or prediction, but it seems to us that stock values have been stress tested pretty well and yet held up remarkably well.

We will continue to assess the tax issue vis a vis any tactical moves which might be appropriate in the weeks to come, but we thought it would be very helpful to consider the broader economic picture which under girds all stock prices over the long term.  In short, there is no need for panic or even extraordinary defensive moves at this time.

Coming as soon after our last analysis as this does, we realize we’ve thrown a lot at you.  But we believe it’s important to keep you informed as we work through the major issues which will impact investment portfolios.  Please give me a call if you’d like to discuss any of the above or any of the points in our last commentary.