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The CXO Advisory Group LLC offers this summary of outputs from our Real Earnings Yield (REY) Model and our Reversion-to-Value (RTV) Model of stock market behavior as frameworks for thinking about current U.S. stock market valuation.
The REY Model, a Fed Model variant, assumes that investors require an aggregate equity earnings yield reasonably higher than the total or core inflation rate, but with a potentially time-varying sensitivity to new inflation rate data. In short, the aggregate earnings yield rises and falls with a perceived long-run inflation rate.
The RTV Model assumes that equities in aggregate revert to a mean valuation level (average price-to-earnings ratio).
To accommodate the possibility of structural breaks in the investing environment, both models have short-term (moving three-year history) and long-term but still "modern" (since 1990) versions.
We normally update this section after the close on each trading day.
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Status - Context - The Big Picture
As of the market close on 7/18/08...
Based on trends in corporate operating earnings and the inflation rate, short-term model outputs currently say the S&P 500 index is about right. Projected corporate operating earnings and projected intermediate-term total and core inflation rates specify a declining aggregate market valuation over the the next few months. The volatility of model outputs reflects the underlying volatilities of inflation and earnings forecasts.
The following statements now apply to 9/30/08, 12/31/08, 3/31/09 and 6/30/09.
The REY Model based on total inflation projects S&P 500 index values of 1215, 1264, 1425 and 1561 at the ends of the next four quarters.
The REY Model based on core inflation projects S&P 500 index values of 1229, 1274, 1436 and 1567 at the ends of the next four quarters.
The RTV Model projects S&P 500 index values of 1236, 1277, 1441 and 1576 at the ends of the next four quarters.
Earnings projections indicate near-term decline and longer-term growth, with recent actuals matching projections but projections for future quarters falling. The June 12-month trailing total (core) inflation rate is higher than (higher than) predicted, thereby shifting downward (shifting downward) the stock market projections of the REY Model based on the total (core) inflation rate. July inflation data is due for release 8/14/08.
For the REY Model based on total (core) inflation, the standard deviation of daily differences between historical modeled and actual values of the S&P 500 index since 6/30/05 is 3.2% (3.0%). Principal risks to this model are: (1) inherent model limitations as indicated by backtest statistics; (2) surprises in corporate operating earnings; and, (3) surprises in the inflation rate.
For the RTV Model, the standard deviation of daily differences between historical modeled and actual values of the S&P 500 index since 6/30/05 is 3.3%. Principal risks to this model are: (1) inherent model limitations as indicated by backtest statistics, and (2) surprises in corporate operating earnings.
The following chart plots the actual S&P 500 index and the outputs of the two models since the beginning of 1990.
Comparing the REY Model based on total (core) inflation with actuals: the average daily difference is 0.0% (0.0%); and, the standard deviation of daily differences is 15.8% (17.6%).
Comparing the RTV Model with actuals: the average daily difference is 4.1%; and, the standard deviation of daily differences is 20.1%.
Note that the long-term models tend to be more optimistic than the short-term models because historical data (average price-to-earnings ratio and average gap between earnings yield and inflation rate) include the very unusual Internet bubble period. Evolving financial markets hypotheses, investment vehicles, regulations and information access/processing capabilities make the normality of any given period suspect.
