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.

Interesting T Bone. Yes, your model is incredibly sensitive to inflation much like any discounting exercise. Here is another thought, might the equity risk premium be a bit lower because of such low nominal rates. If I read your piece properly that assumed rate looks like an ERP methodology. Interesting, but just cuff the inflation assumption - you know what Keynes said about models: better to be vaguely right than precisely wrong.

JR

Posted by: JR | April 24, 2009 at 02:17 PM

JR-

You're right. The way to look at it is the real rate of return for equities priced in today is 4.5%. Plus you own the inflation hedge. If high grade corporate debt is providing roughly the same nominal return based on a 2% inflation assumption (which it roughly is), you are getting the same return with less risk but instead you are short the inflation hedge. If you have a clear view that inflation will be low, favor fixed income, if you have a clear view that inflation will be higher than 2%, favor equities. If you aren't really sure (like most of us), then own both and you're diversified.

Posted by: Tyler | April 25, 2009 at 06:38 AM