The forward price-to-earnings ratio of the S&P 500 index rose to 14 on May 3, the highest since April 2010. Over the past seven weeks, the forward earnings of the S&P 500 has leveled out around a record high of $115 per share. Now that the index is already within sight of my year-end “rational exuberance” target of 1,665, what is the upside in an “irrational exuberance” melt-up scenario? Let's review the potential upside suggested by some valuation models.
In 1997, I noticed that the second section of the Fed's Monetary Policy Report to Congress included a chart and a brief discussion of the close fit between the 10-year Treasury bond yield and the inverse of the S&P 500's forward P/E. I dubbed it the "Fed's Stock Valuation Model." The model became instantly popular and controversial, as discussed in a Wikipedia article about it.
Ironically, after I “discovered” the FSVM, the Fed never mentioned it again, and it hasn't even worked for the past two decades. It was bullish on stocks during the bull markets of the previous and current decades. But they were driven mostly by rising earnings, while the secular trend in the valuation multiple was downward. The FSVM currently suggests that stocks are 75% undervalued relative to bonds. Alternatively, bonds are grossly overvalued relative to stocks.
A simple alternative to the FSVM is the Rule of 20, which compares the forward P/E of the S&P 500 to the difference between 20 and the consumer price index inflation rate on a year-over-year basis. Currently, it shows that the P/E should be 18.5, well above the market's current P/E of 14. That would put the S&P 500 at 2,133, or 32% above the close on May 3.
A hybrid valuation multiple that combines the Rule of 20, the FSVM, and our “Blue Angels” multiplies the latest forward earnings of the S&P 500 by the P/E derived by subtracting the 10-year Treasury bond yield from 20. The result shows that the S&P 500 should be around 2,100.
Source: Ed Yardeni — Ed Yardeni is the president and chief investment strategist of Yardeni Research Inc., a provider of independent investment strategy and economics research for institutional investors.