Tuesday, October 29, 2013

Applying the Gordon Growth Model to the S&P 500

The Gordon Growth Model is a very old and very useful stock valuation model. It's based on the insight that the value of stock today is the present value of all future dividends the stock holder will receive. If one can argue the dividends will grow at a constant rate, then we can use the simple Gordon model:

where P is the value of the stock today, D is the dividend in one year (normally), r is the required return on the stock, and g is the expected growth rate of the dividend. Now, using the simple model takes a lot of care, and shouldn't be applied to every stock. But, it does make sense, as an initial approach, to apply this model to the S&P 500 so we can try to get a sense of the fair value of the S&P 500. 

Now, according to Prof. Shiller's data, the dividend you would receive if you held one share of the S&P 500 index (yes, it's not possible but this is a theoretical exercise), is 34.4. Note the current index level (which can be interpreted as the price of one share of the index) is 1776. 

I built a little table to see how reasonable the current level of the index is, given the dividend. The range of the required return (r) that I use is 5-8%, and the growth rate (g) range is 0-4%. The range of index values I generate is 430 (required return of 8%, growth rate of 0%) and 3444 (required return of 5%, and growth rate of 4%). In only three situations can I generate a value above the current index value: required return of 5% and growth of 3.5% or 4%, and required return of 5.5% and growth of 4%. 

It is important to note that a reasonable range of required return for the S&P 500 is 6-8%. The historical (back to 1871) average growth rate of dividends is 3.5%. For those values, the range of index values I find is 765 - 1377. Note that, using the current dividend yield (34.4/1776) and growth rate, we can calculate the current total return as around 5.5%. That seems abnormally low to me.

According to my little exercise, the S&P 500 is currently above most reasonable values I can generate. I think that growth of 3.5% is rather high to expect right now. Most estimates I see are between 2-3%. That means the S&P 500 is going to drop down. I don't know when, so rather than shorting the index, put options are a better choice. 

Certainly we can "tech up" the situation, which will be my next exercise. Notably, we can include risk aversion measures, because if risk aversion is down, then it is conceivable that required return is lower than normal. That could justify higher stock valuations.

Sunday, October 27, 2013

Stock Prices are High. So what?

Actually, according to the S&P 500, stock prices have never been higher, in nominal terms. In real terms (data from Prof. Shiller of Yale), the S&P 500 price level is at the 3rd highest point it's ever been. The first highest was at the height of the tech boom, and the second highest was at the height of the real estate boom. But the issue is not only the height of the price level, it's the relative height. In general, we prefer to look at normalized price measures, like price-to-earnings ratios (P/E). Earnings are defined as the trailing-twelve-months net income divided by shares outstanding. In real terms, P/E right now is 23.5 (again from Prof. Shiller's data), and the long-run average (going back to the late 19th century) is 16.5. The 60-month moving average of the P/E is 20.42. That means the P/E (and so price) is relatively high.

There are some reasonable arguments for a higher P/E. The first is that fundamentals (earnings, growth, dividends) are expected to be higher in the future. While this is possible, it is not normally the case empirically speaking. In the data, higher prices are followed by low returns, not by higher earnings/growth/dividends. Earnings are certainly doing well, as they recently reached one of their highest points (in real terms) since the late 19th century. But earnings aren't the whole story, growth is also important. There is good evidence that one source of higher earnings was reduced investment, which will compromise future growth. Now, investment has recovered, and earnings have turned downward, so we'll see what happens there.

Another factor that can drive up stock prices is a reduction in the required return. Required return is composed of the risk-free rate, plus risk factors. Required return can decrease because the risk-free rate goes down (we know this has happened, but is starting to increase again). It can also decrease because: risk decreases (not buying that story) or risk aversion decreases (meaning people require a lower risk premium for a given level of risk). Many people, me included, would argue the risk-free rate is abnormally low right now and that's driving at least some of the price increase. There is also evidence the equity risk premium is abnormally low right now, but that's usually estimated using price data, so it is rather mechanical and therefore I don't like to appeal to that argument.

In my view, stock prices are relatively high right now. What should we expect if that's the case? We should expect future long-term returns to be relatively low. That means, given dividends are stable, stock prices will drop. Now there are several moves one can make to take advantage a price drop. First, you can short specific stocks, or the whole market (SPDR S&P 500 tracking shares, for example). Second, you can buy put options on same (recognizing that puts expire!). Third, you can go long on commodities that tend to do well in market crashes, like gold & silver.

The problem with any short position is that you may lose money before you make money, since the timing of the market downturn is anything but certain. So when your options expire out-of-the-money, you'll lose the premium. A short position could get called, and you may have to buy back at a loss. At least long positions can be held for much longer than shorts, so those are less risky in that sense. Of course, if you think I'm wrong, the answer is simple: go long on stocks! But don't say I didn't warn you.

Sunday, October 6, 2013

Walker shows 'em who's boss

Governor Walker has provided the exemplar way to deal with a federal shutdown.  The National Park Service apparently tried to shut down many of the parks in the Badger state that receive federal funding - even though a majority of dollars come from state and not federal coffers.

What did Governor Walker say when the NPS ordered the parks to close?  He said, nope!  They'll stay open.

We need more governors like Walker who correctly understand that the feds don't always call the shots.

Thursday, October 3, 2013

Non-essential government? Then why do we have it?

"That the government could even have services it considers non-essential is ludicrous. It is a blatant display of an oversized government, with excessive programs." ~ Competitive Enterprise Institute.

If government is so essential to our lives, then the mere existence of non-essential government is by definition a fraud, waste, and abuse.

Now is also a perfect time to take inventory of the national government.  Any feelings of dismay over a federal shutdown should be dwarfed by feelings of contempt and disgust for an abominable federal bureaucracy.

Coursera Math Class

I'm enrolled in my second Coursera course - Pre Calculus.  My math skills are waning and this course provides the convenience and price (free, except for your time) I'm looking for in a remedial math course.  It's being taught by two Ph.Ds from UC-Irvine. 

It's a nine week course and class starts Sunday, October 6, 2013. 

Here's the link in case you're interested: https://www.coursera.org/course/precalculus

Wednesday, October 2, 2013

Obama touts benefits of ACA (but not costs)

Here’s the scene: Speaking from the Rose Garden, our president, flanked by a few poor souls who lack health insurance, decried that Republicans were trying to thwart some Americans’ access to healthcare.  The implication is “why would anyone want to deny someone access to healthcare?”  Why, that’s inhumane!  The president went on to say that thanks to him, these folks now have access to affordable care.

I guess we’re to believe that benefits such as healthcare flow like honey from government coffers.  “Why, without someone in Washington fighting for us, we’d have no healthcare!” many might proclaim.

The undeniable and inescapable fact, though, is much less appealing:  the government must first take from Group A and then give to Group B (here, in the form of health insurance).  Some will be made better off ONLY at another’s expense.  If I robbed John at gun point and used the stolen cash to visit the dentist, I’m still a thief.  Theft is theft.  However, our government can perpetrate the same crime except now it’s legal theft.  What was once considered outright stealing has been deemed humanitarian, compassionate, civilized, etc.
A more honest approach would have been for the president to man-up, face the cameras and accept partial responsibility for the lousy economy and lack of jobs – jobs that could have provided these folks with affordable health insurance.

Tuesday, October 1, 2013

A Visit to the DMZ

Our (big) boss visited the Korea field office last week, and we made a special trip to the DMZ.  While we were visiting the Joint Security Area or JSA (the famous blue houses behind us), we noticed a group of North Koreans atop the building behind us looking our way.  I couldn’t help but wonder what they were thinking?

At the South Korean DMZ - Sept 2013

Our tour guide (a U.S. Army soldier) told us that he’s only seen North Koreans gather like this once or twice.  He explained that the border isn’t open to ordinary North Koreans – for good reason.  They’d all attempt to flee. Only high-ranking officials within the DPRK visit the North-South border.  I would have loved to have been a fly on the wall during their visit.  What were they talking about?  Were they showing the people how much better off they have it compared to the South?  It was a very curious sight.