A Fair Market Value Update
NEW YORK ( Real Money ) -- I am fine-tuning my S&P 500 fair market value calculation.
As a reminder, my starting point in determining exposure is valuation: My fair market value calculation is based on four different economic scenarios and assigning probabilities to each result.
In looking at these four outcomes, I am making the following changes this morning:
- I am lowering the probability of an above-consensus reacceleration in domestic economic activity to zero (defined as +3% for 2012 real GDP growth);
- I am modestly increasing the chance of sub-1.5% 2012 real GDP growth; and
- I am slightly raising the likelihood of my baseline, muddle-through scenario (defined as 2012 real GDP growth of between +1.5% and +2.0%).
I am also increasing the theoretical P/E ratios attached to each of the four economic outcomes by half a multiple (+0.5). This reflects my expectation for a more benign inflation rate and a modestly lower interest rate assumption in 2012 relative to my prior projections.
Based on those changes, I have slightly increased my calculation of the S&P 500's fair market value from 1335 to 1360.
My base case of muddle through, with a near two-thirds probability, yields an S&P price target of 1430, somewhat higher than my fair market value calculation of 1360. Below-consensus growth, which is accorded about a one-third probability, yields an S&P target of 1235, which is well below both the current level of S&P cash of 1382 and my 1360 fair market value estimate.
While there could be overshoots, in all likelihood, I expect the S&P 500 to be contained within the upper range of these two likely outcomes of between 1235 and 1430 for the remainder of the year. My guess is that 1300-1430 represents a reasonable trading range for the balance of 2012. (Remember the 1235 target has been assigned only about a one-third probability, so I adjust my trading range higher.) This yields about 82 S&P points of risk from the current S&P cash index and only about 47 points to the upside, for a slightly unfavorable risk/reward. (It should be noted, however, that in its extreme and not adjusting for the melded outcome probabilities, a much broader trading range (1235-1430) is represented, with a far more unattractive risk/reward ratio of nearly 150 S&P points down to only about 45 points up from Monday's closing S&P cash of 1385.)
My methodology, though appearing precise, recognizes the difficulty of attaining investment precision given the numerous moving parts (economic, interest rates, sentiment/psychology and exogenous factors) in its calculation.
Below is the criteria and methodology I use to evaluate the S&P 500 and upon which I conclude that fair market value is approximately 1360, or about 2% below yesterday's closing price of 1382.