Tuesday, August 23, 2011

SP500 Price, Value, ahhhh! The CNBC Talking Heads are going to make my brain explode

A Wall Street strategist once said that when he walks into a financial services firm and they have a television programmed to CNBC, it's the same as walking into a hospital and they have their TV programmed to General Hospital. That is, it's laughable that doctors would learn anything from General Hospital and thus, it's laughable that any one worth their salt in finance can learn anything from the talking heads on business television.

The past few weeks have seen large gyrations in the stock market. I have seen friends and colleagues, the same who haven't looked at their 401Ks since the last crisis, frantically trying to log in to their plans website. The heads on CNBC are running about with their hair on fire, trying to claim the crown of most-over-the-top. The more the heads screamed the more my friends tried logging into their account. The friends told me the websites to change their allocations were down for days. ( An ancillary point, is that besides doing the minimum to garner the company match and then only plugging those funds into the cheapest bond fund offered, is insane.)

My only investment besides cash since 2006 has been Gold. In December 2008 I invested a huge amount of my portfolio 15% to that class and have just let it run to almost 30% now. The thing is I should re-balance it but I don't want to just put the money in cash, so the market gyrations might provide a buying opportunity. So I opened up the spreadsheet and did some crunching of the numbers.

The first thing I do is go to S&P's website and download the earnings data. Then I try and estimate how good the analysts estimates are for reported earnings. So the analysts proclaim that reported earnings will be 95.67 for 2012, if you divide that by the BAA bond yield of 5.67% you get that the SP500 should be worth 1,660.94. At today's current price it 1,140 it would be a screaming buy. [This is a hybrid of the "Fed Model" and a Dividend Discount Model, basically the price of the index will equal the earnings divided by the discount rate. (I use earnings because companies do stock buybacks now instead of dividends because they are economically the same and there is a tax advantage buying back stock)]

However, what if the estimates are too rosy, corporate earnings look pretty high relative to GDP. With macroeconomic gyrations, we might go into a recession and earnings could plummet precipitously. In S&P's own spreadsheet earnings in 2008 were 14.88 after being 66.18 in 2007. If we take the average annual earnings over the past 10 years earnings have been about $52 per year. If we divide that by the BAA yield we get a fair value of 917.81, thus we are overvalued at current levels.

So which is it are we overvalued by 24.2% or are we undervalued by 45%. This is why economist will always be employed, that is, there is a lot of tea leave reading in the economic circles. So I include a different method altogether to gain some insight into momentum.

Basically, by looking at the 200 day exponential moving average (EMA) I can gain a look at how people feel about the current valuations. When the index drops below the EMA the standard deviation of each day's return elevates and not in a good way because of economic uncertainty. When you are above the EMA the standard deviation lowers and the returns are more positive. Basically, the method tries to see the confidence of the market makers. Unfortunately, we are about 11% below the EMA currently. So it is not a good time to buy based on momentum.

Now, if the market were to plunge even further down to levels closer to a 9 handle, I would definitely pare my gold holdings back to 15%, and bring up my equity exposure to 20%. So I wait for the fire sale.

Imagine if CNBC had a sane talking head who did a quick analysis like above and said "Meh, prices looked elevated. I took this opportunity to sell some of my holdings and will wait for the prices to drop. The further prices drop the more earnings I get. This is akin to waiting to buy a 60" LCD televisions set after the Super Bowl (when prices drop) versus buying a 50" set before." The important thing to remember is that you are buying earnings; you are not buying a lottery ticket when you purchase stock.

PS~ Alternatively, if the news picks up and the index pierces the EMA I would take a short time frame position in SPX, but not rotate out of my over-weighted gold allocation

The green arrows are when you would want to buy and the red arrows are the sells. Specifically, I would buy when I am in the range for what the index should be bought for and you pierce the 200 day EMA, and I would sell when the index seems too high in price to earnings and it blows through the EMA.

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