Appendix E
30 Percent Value Gap in S&P 500 Closed by Rise in Treasury Yields, Price1
When I first wrote about the Risk Premium Factor (RPF) Valuation Model on SeekingAlpha.com on September 28, 2010 (see Appendix C), I described how the S&P 500 appeared to be undervalued by about 30 percent based on expected 2010 earnings and current yield on 30-year Treasury bonds. The S&P 500 was at 1,142, and the 30-year Treasury was yielding 3.73 percent.
Because lower Treasury yields result in a higher predicted price in the model, I calculated the predicted level of the S&P 500 at 1,505, using a 4 percent yield to be more conservative. This still resulted in a large valuation gap, suggesting that the S&P 500 was undervalued by about 30 percent. I cautioned that in addition to a change in the price of the index, the gap could be closed by a changed in interest rates or earnings. The gap has closed—today, at 1,329, it looks like the S&P 500 is fairly valued with an intrinsic value suggested by the RPF Model of 1,315.
HOW DID THE GAP CLOSE?
The RPF Model bases predicted value on the risk-free rate as measured by Treasury yields and trailing operating earnings. The formula is: P = E / (Rf × (1 + RPF) – (Rf – 2 percent) – 2.6 percent), where:
P = Predicted price (value of S&P 500 Index).
E = Actual earnings (annualize operating earnings for the prior four quarters as reported by S&P). Earnings, while not ideal, are used as a proxy for cash flow and seem to work very well.
Rf = Risk-free rate as ...
