Forecast came true

Intrinsic Value of the S&P 500 (November Update)
30 october

Using a few main factors, we can derive the intrinsic value of the S&P 500 (SPX) or back out growth expectations and/or risk tolerance in the market.

We need the following:

- Current value of the index

- Earnings yield

- Dividend yield

- Cash payout ratio (i.e., what percent of earnings are paid back to shareholders)

- Expected earnings growth rate

- Current risk-free rate

- Equity risk premium (i.e., how much more yield do investors expect out of stocks versus a safe asset)

- Long-run economic growth expectations

- Long-run inflation expectations

The earnings yield of the index is approximately 3.89%. Dividend yield around 1.87%.

Cash payout ratio can be assumed at about 80%. Historically it’s trended at about 75% but a dearth of viable investments and low earnings relative to historical norms has pushed this higher in recent years to help keep shareholders onboard.

In terms of a long-run growth rate, financial assets can’t perform beyond their earnings growth indefinitely. Accordingly, we should expect stocks to yield at about the long-run growth rate of the economy – approximately 3.5%-4% – using some combination of 1.7%-2.0% growth and 1.7%-2.0% inflation.

The risk-free rate is debatable. Many use the 10-year US Treasury as a convenient safe benchmark, which is fine. One can also use the rate of return on cash, which also makes sense mainly because people invest their money to earn a return in excess of whatever interest they could get on cash. This is what I’m personally using in this exercise wherein I use the 3-month Treasury as a proxy. It’s currently trading at 1.10% as of the time of writing.

The equity risk premium (ERP) is something that can be sensitized over a range. This reflects a discount rate or a returns expectation in the market. If the ERP is 6%, for example, then this assumes investors expect a 6% return above that of cash. At a 1.10% return on cash, that’s 7.10% in nominal returns, or about 5.1%-5.6% in real terms assuming an inflation range of 1.5%-2.0%.

For long-run growth expectations I use 1.8%, which accords with the US Federal Reserve’s expectations and 1.8% for inflation over the next ten years.


If we run these assumptions over an ERP (i.e., nominal returns expectations over cash) range of 5.0%-7.0%, then we get valuations going from 1,810 to 3,260 for an intrinsic value.

At 5.5%-6.5%, a range of 2,040 to 2,720.

Below represents a pricing curve based on various required rates of return. Investors with higher returns expectations will price the index lower than those with lower returns expectations.

A 6% ERP (or 7.0%-7.1% nominal returns expectations) would place the value of the index at 2,330.

If we were to back out a value based on the current mark of the index by adjusting the equity risk premium, we’d get an ERP of 5.66% – 11 bps lower than last month – or 6.76% forward nominal returns expectations. This is revised down 7 bps from last month’s 6.83% projection.

This comes to about 4.87% in real terms using 10-year breakeven inflation expectations.

The following graph shows valuation levels of the S&P 500 at various risk premiums – i.e., expected returns above that of cash. Year-over-year earnings growth is set equal to the 3.6% assumed long-run level (combination of 1.8% real growth and 1.8% inflation).

The graph below shows valuation levels of the S&P 500 using a 6% equity risk premium and forward long-run nominal growth ranging from 3.00%-4.50%, at 25-bp increments.

Bearish projections of long-run economic activity would discount the S&P’s fair value back to 1,990. 2% growth and 2% inflation would put it at 2,630, or slightly undervalued. Bullish expectations of 2.25% growth and 2.25% inflation would estimate its fair value about 22% higher at 3,140.


Since February 5, 1971 – the first day the S&P 500, Dow Jones, and NASDAQ traded simultaneously – stocks have averaged about 7.3% in real terms.


This means stocks are overvalued if we’re going purely in terms of returns of the past, mostly as a coordinated central bank effort to price up equities in order to create a wealth effect.

Investors currently should expect annualized forward real returns of about 2.4% below this.

In the end, the long-term growth rate of the economy dictates everything. If we expect growth and inflation to average 1.8% each over an indefinite period of time (i.e., 3.6% nominal GDP), we’re looking at low rates of return. If we take this 3.6% nominal growth rates and assume 2% in dividends, this gives us just 5.6% in nominal forward returns with interest rates being the factor that could push this number up or down.

So it’s fairly safe to say we’re looking at anywhere from 5.5%-7.0% forward nominal returns (approximately 3.5%-5.0% in real returns).



Will the S&P 500 move above 2,600 by the end of November?

Agree = Yes

Disagree = No

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Intrinsic Value of the S&P 500 (November Update)

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Forecast came true

Finished above 2,600