Stock Market Status

The CXO Advisory Group LLC offers this summary of projections from the Real Earnings Yield (REY) Model and the Reversion-to-Value (RTV) Model of the U.S. stock market as ways of thinking about current equity valuation.

The REY Model assumes that investors require a positive but somewhat variable gap between aggregate equity earnings yield and the total and core inflation rates. It seeks to infer future behavior of that gap from historical data.

The RTV Model assumes that equities in aggregate tend to revert to some mean valuation level (average price-to-earnings ratio, P/E). In other words, P/E is "sticky" over reasonably short periods.

Both models depend on a technical Earnings Forecast that assumes the aggregate corporate operating earnings growth rate continually reverts to a long term trend, with strength of reversion to trend related to degree of deviation from trend.

The REY Model depends also on a technical Inflation Forecast that assumes a combination of persistence and momentum in the inflation rate.

The following chart shows the model projections for the S&P 500 index through June 2010 as generated by the models. It also shows a simple linear extrapolation of the average monthly gain of the index during April 1989 through June 2009 ("Dummy"). For comparison, the chart also shows the change in the actual S&P 500 index from the end of June 2009 to date.

Note the following sources of uncertainty and potential inaccuracy in the models, as stated in the detailed model descriptions:

• Empirical measurement of earning growth rate reversion indicates substantial variability in the reversion process, and this variability may be non-normal (subject to Black Swan disruptions).
• Empirical measurement of inflation rate persistence and momentum indicates substantial variability in these processes, and this variability too may be non-normal.
• The above foundational beliefs of the models (see the "Rationale" sections of the model descriptions for details and some tests) may be incorrect or substantially imperfect.

There were major changes to the models in February 2009, as follows:

• Replaced Standard & Poor’s earnings forecasts with the earnings growth reversion model based on predominantly historical data to suppress analyst earnings optimism.
• Replaced one short-term (rolled quarterly) and one long-term version of the model with a continual monthly rolling regression to make the models more responsive to new data, risking model stability.

Since February 2009, the following surprises have significantly impacted model projections:

3/2/09: Even though the previous week Standard & Poor’s had 93% of S&P 500 fourth quarter 2008 earnings in hand (which the models were treating as "actuals"), yesterday the aggregate S&P 500 operating earnings for the fourth quarter of 2008 dropped by $5.00 as the number of companies reporting rose to 98%. That change reduced actual 2008 annual aggregate operating earnings by about 10% from $54 to $49, bumping the models downward accordingly. The surprise is that an almost complete tabulation of quarterly earnings could be so far off that an incremental change greatly affected annual earnings. The Earnings Forecast assumption of reversion to a long-term earnings growth trend does not predict such violent changes.

3/31/09: Advancing the rolling regressions to incorporate March 2009 data and correcting a data entry error in the REY model calculations lowered the RTV model projection by a few percent and raised both REY model projections by a few percent.

4/30/09: Advancing the rolling regressions to incorporate April 2009 data had little effect on the RTV model projection but raised both REY model projections by a few percent.

5/1/09: With Standard & Poor’s now having well over half of S&P 500 first quarter 2009 earnings in hand, we replaced our forecasted earnings for the quarter with Standard & Poor's estimate. This change pushed both the RTV model projection and the REY model projections down by several percent.

5/13/09: Even with more than 80% of companies already reporting, Standard & Poor’s bottoms-up estimate of S&P 500 first quarter 2009 operating earnings has declined substantially each of the past two weeks, pushing both the RTV model projection and the REY model projections further down.

5/30/09: Advancing the rolling regressions to incorporate May 2009 data raised all model projections by several percent.

6/30/09: Advancing the rolling regressions to incorporate June 2009 data raised the RTV model projection by about 10% and the REY model projections by several percent as investors continue to bid down the stock earnings yield.

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