FED Model - Updated Through January 26, 2007

I wrote a post in February 2006 in which I argued that the S&P 500 was undervalued. Since then, the S&P 500 has risen from about 1283 to 1422, a return of 10.83%, excluding dividends. This is a strong gain and I think that the S&P 500 has further to go. Relative to bonds, the S&P 500 still appears to be undervalued.

According to Standard & Poor's, the projected reported earnings through 12/31/07 for the sum of the components of the S&P 500 is about $89.10/share. As discussed above, the S&P 500 index currently trades at about 1422. Accordingly, the forward P/E ratio of the S&P 500 index is about 15.96* (1422/$89.10). This is slightly higher than the historical P/E ratio of around 14-15. However, bonds are still more richly valued than their historical averages. Other asset classes such as real estate and commodities are also richly valued right now and have been for several years. As I wrote last February, it seems inevitable that stocks will eventually catch up to the performance of these other asset classes.

Stocks have been weighed down over the past couple years in large part due to high energy prices and a FED that had been steadily raising short-term interest rates. However, consumer price inflation is still low and bonds are expensive relative to historical averages. The yield on the 10-yr US bond is currently about 4.88%. The earnings yield on the S&P 500 based on estimated 2007 earnings* is about 6.27% (i.e., the inverse of the 15.96 P/E ratio). The earnings yield on the S&P 500 is therefore about 1.45% higher than the 10-yr bond yield. This is still a large disparity and will probably shrink over the next few years as the S&P 500 outperforms the 10-yr bond.

2007 should continue to be a good year for the S&P 500. The S&P 500 probably won't increase in value every month, but even after accounting for a pullback or two this should be a good year nevertheless.

* I used estimated "as reported" earnings in calculating the 2007 estimated earnings. Many stock market analysts use estimated "operating earnings" in calculating forward P/E ratios. The "as reported" earnings account for miscellaneous supposedly non-recurring "one-time" charges and expenses deducted from operating earnings. The "as reported" earnings provide a more realistic estimate of earnings because such miscellaneous non-recurring "one-time" charges and expenses occur every single year. It seems disingenuous to not factor them into the calculation of the forward P/E ratio.