In my first quarter market update, I arrived at a target S&P 500 level of 541 to target an 8% long term return. Certain of the data points have been bugging me, though.

First, the data set I had access to excluded the 1950s, when earnings growth was strong. I backed into some earnings data for that period (by dividing the dividend yield data into the index value and assuming a 55% earnings payout). This raised my assumed long term real earnings growth rate from 1.2% to 1.6% and raised the trend earnings value to $54.70 per share from $50.37.

The other wild card is inflation. Inflation from 1947 to 2008 averaged 3.7% per year (geometric mean), which included the inflation plagued late 1960s and 1970s. Bernanke uses 2% as an implicit target and Greenspan averaged 2.5%-3.0% during his reign.

I have been using a 2% assumption, because (1) that is what Bernanke is targeting, (2) I hope we've learned something since the 1970s, and (3) I think the natural undertow is a deflationary one given the high debt levels in the US. Given the aggressive actions the Fed has taken to date, it is tempting to assume a higher rate of inflation for the future. FYI the treasury market (distorted somewhat by assumed Fed purchases) is pricing in LT inflation of 1.8%.

Assuming 2% long term inflation: The current S&P level is pricing in an annual return of 6.8%. To arrive at a 7% return, we need a S&P level of 818, and to arrive at an 8% return we need a level of 630.

Assuming 2.5% long term inflation: The current S&P level is pricing in an annual return of 7.3%. To arrive at a 7% return, we need a S&P level of 964, and to arrive at an 8% return we need a level of 714.

Assuming 3% long term inflation: The current S&P level is pricing in an annual return of 7.8%. To arrive at a 7% return, we need a S&P level of 1173, and to arrive at an 8% return we need a level of 822.

Assuming 3.7% long term inflation: The current S&P level is pricing in an annual return of 8.5%. To arrive at a 7% return, we need a S&P level of 1685, and to arrive at an 8% return we need a level of 1044.

In other words, the model is incredibly sensitive to the assumed inflation rate. If you think long term inflation is going to be high, the stock market is reasonably valued or even cheap. If you think long term inflation is going to be low, the stock market is somewhat expensive. Of course, if inflation is going to be low, interest rates will remain low and perhaps the required return for equities will come down as well.

Figuring out the path of long term inflation is the pivot upon which your investment permormance will depend.