8/30/2015 How to Calculate Fair Value of the Secular Market

The recent gyrations of the market have brought back the question of bubbles and market trends.

A “bubble” is an abnormal inflation of a type of investment in proportion to other investments.  The classic is the Tulip mania of the 1630s. More recent episodes are the Nasdaq frenzy of the late 1990s and the housing bubble of the previous decade.

In each case, the investment in question edged out other investments and became inflated in value in relation to its typical place in the market.

I’ve noted many times that quantitative easing has inflated most assets together. Although there are some distortions, the fact remains that the market as a whole is not in a bubble.

To calculate a “bubble” environment I have multiplied the birth rate plus 46 years (i.e. the average age of the American work-force) by the Fred M1 money supply and plotted their current deviation from a 1959 to 2015 regression.  That value gives a current deviation of 0.0721797.

Next, I’ve done the same for the S&P itself during that same time period, with a current deviation of -0.035329.

If we SUBSTITUTE the demographic * money supply deviation for the price deviation we see a fair value for the S&P to be 2250.

I’ve plotted this graphically:

A few points. First, secular bear markets show fair value trailing behind price, while secular bull markets show price trailing behind value.  We certainly DO have an artificial market environment, with price and value tracking in lock-step. Ordinarily this would still be a secular bear, but quantitative easing has camouflaged that fact.

As I’ve argued routinely in previous posts, the market isn’t due for a crash because it actually hasn’t risen in real value. It just looks like it has been going up because of all the M1 money supply expansion. Even Shiller’s CAPE ratio is distorted by the disconnect between inflation and money supply.

The next obvious point of the graph is what a bubble actually looks like.  The 2000 and 2007 peaks are wildly inflated, even on this logarithmic chart. They are spectacularly obvious.

And the final point is that the market is not above fair value.  Instead, it is almost 12% below fair value.

Bear markets are routine.

Crashes are not.

A bear market can come at any time, and the leading / lagging sectors show a preference for defensive sectors right now.  I do expect more correction to follow, even up to a bear – but I do not expect a 1929, 2001, or 2008 style crash.  The worst we could see would be a 1987 type event – annoying, but not disastrous. I would be afraid of too much margin right now, but there is no reason to dump non-leveraged investments.

I don’t time anyway, of course. But even if I were a market timer, I’d leave my non-leveraged investments in place.

Tim