Appendix D
S&P Index Still Undervalued1
Despite overvaluation concerns, the rise in the S&P 500 Index appears to be earnings driven and not speculative. The Risk Premium Factor (RPF) Model shows that the S&P 500 is undervalued by about 7 percent, narrowing from the 30 percent undervaluation estimate that I reported in my September 28, 2010, article (see Appendix C) and the 20% that I reported on November 8, 2010. This suggests continued opportunities for investors, corporate buybacks, and mergers and acquisitions (M&A).
The narrowing of the gap was caused by rising Treasury yields, which drive down predicted levels coupled with an increase in the index. While continued increases in earnings in 2011 should be expected to drive the market higher, investors should keep a cautious eye on interest rates.
The RPF Model is built on a simple constant growth equation where:
This formula explains S&P Index levels with good accuracy for 1960 to the present using only the risk-free rate, S&P 500 operating earnings, and some simplifying assumptions. Figure D.1 shows this relationship since 1986.
Just as overvaluation during 1999 to 2000 is apparent in Figure D.1, recent undervaluation is also visible. For more background and graphs going back to 1960, you can read my summary of the RPF Model (Appendix C) or the full paper (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1663812). Figure ...
