Economic Insights - August 2012

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While America’s equity markets have rallied sharply since October 2011, with the S&P 500 up 22 percent, the stock market has been stuck in a fairly narrow range for 18 months.  For instance, the Dow Jones Industrial Average has hovered between 10,650 and 13,280, well below the October 2007 high of 14,165.

Much of this stagnation is due to the fact that a wide range of problems has been priced into the markets.  Prolonged slow economic growth and the increasing burden of big government will continue unless we see a dramatic change in Washington.  That will mean less in the way of future after-tax profits, higher deficits, and potentially higher taxes.

Since all of these factors are already built in, if the future turns out to be less dour, we can expect a rapid rise in stock prices.

Using a capitalized-profits model to find the fair-value of equities, we can divide corporate profits by the current 10-year Treasury yield of 1.5 percent, and then compare the current level of this index to each quarter for the past 60 years.  This indicates a fair value for the Dow at an absurdly high 63,000.  That’s almost five times the current level.

Obviously, this makes no sense.  That’s because long-term interest rates are being kept artificially low by the Federal Reserve.  However, if we adjust the model and assume that without interference we’d have a 10-year Treasury yield of 5 percent, we get a fair value of 18,700 for the Dow and 1,985 for the S&P 500.

To many observers, even this seems a bit high.  Why?  Because corporate profits are now at a record high, representing about 13 percent of GDP.  It is much more conservative to assume that these will revert to the historical norm of about 9.5 percent. 

Combining this more conservative value for corporate profits with the historical norm of 5 percent for the 10-year Treasury yield gives us a very rational fair value for the Dow of 13,900 and 1,475 for the S&P 500. 

In short, even if profits fall 25 percent and interest rates more than triple from current levels, today’s broad stock market indices are still undervalued.

This doesn’t mean we’re going to see a dramatic bull market emerge tomorrow.  It just means that the upside risks...

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