Friday, December 11, 2009

Our Valuation Model Signals Stocks Are Still Undervalued

Stocks have moved a long way since March and there are many analysts that are calling for a correction of these gains. We are not in that camp. In an August blog, with the Dow at near 9,200, we showed that our valuation model was indicating that the fair value of the Dow was near 10,900. With the Dow now approaching 10,500, we thought it would be interesting to recalculate the model. The graph shows the valuation model going back to 1960. The red line is the actual annual price of the Dow Jones. The blue bars are the model's output of the predicted values. The ouput is derived from a multiple regression of the DJIA's dividend, earnings, and the yield on 20 year bonds against the price of the DJIA. The way the model works is to mathematically produce what we might call a "normal" price of the Dow based on the historical relationship among the various inputs. Today the model calculates a "normal or fair value" of 11,400 for the DJIA. In addition, remember this is what we call a "coincident" indication of value. Since the model is positively correlated to rising dividends and earnings, a rise in both of these inputs will push the fair value of the DJIA higher. Knowing how the model works, we would not be surprised if the fair value of the DJIA rose to near 12,000 sometime in 2010. We'll revist what the model is saying after 4th quarter earnings are released. Please read the Terms and Conditions at the right.