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Long/Short Investments in L/S Equity: Valuation and Ideas,

The S&P 500 Could Be Up To 8% Overvalued

The day’s main headline revolved around the S&P 500 making a new all-time high at 2137. I believe the market’s current figure has little to do with broader scale economic health and more to do with money being flushed into the equities market due to the low yield of the debt market. It has gotten to the point where government bond ownership is basically pointless if positive returns are the premise for investing in the first place.

Thirty-five percent of the world’s debt is trading at a negative yield in nominal terms and the vast majority is trading at a negative yield in inflation-adjusted real terms. Second quarter corporate earnings, to be mostly released this month, likely won’t be that compelling in terms of actual performance. Analysts tend to low-ball estimates. But there is a difference between beating estimates and actually performing well. Corporate earnings are expected to fall for a fifth straight quarter. The current market is also providing a cash payout – i.e., the sum of dividends and buybacks – of greater than 100% of earnings, which of course is not sustainable long-term.

Based on a simple intrinsic valuation model, where I take the current level of the index, multiply it by an earnings yield and then a cash payout figure that are more sustainable and in line with historical norms – 5.2% and 74%, respectively – I receive the expected free cash flow to equity for each time period. I assume this figure grows each year by 5.4% to reflect a forward-looking estimate based on an expected long-term growth rate of 2%. I then discount these values back to the present using the current risk-free rate (10-year Treasury bond) of 1.434% added to an assumed equity risk premium of 5.5% minus the long-term rate of 2%. Accordingly, I receive a value of 1968 for the intrinsic value of the S&P 500. This would represent an 8% overvaluation based on current levels.

If these results were sensitized to equity risk premium adjustment of +/- 50 basis points (i.e., from 5.00%-6.00%), this would provide a valuation range of 1785-2193, which could represent anywhere from a 16.5% overvaluation to 2.6% undervaluation. The 1968 figure assumes an expected return of approximately 7% on one’s investments, which is approximately in line with historical averages. The chart below shows the results in graphical form, based on quarter-percentage-point increments in the equity risk premium: