“Davidson” Submits:
Subject: Dallas Fed Releases Updated 12mo Trimmed mean PCE Inflation benchmark.
The Dallas Fed released their 12mo Trimmed mean PCE inflation benchmark this morning. This includes the Jun09 and July09 values and was delayed while they went through a periodic review. It should be no surprise that the values are lower as this indicator carries an estimate for cost of housing as well as energy and food. This index “trims” monthly spikes, but includes all relevant expenditures as opposed to earlier “Core Inflation” which simply excludes food and energy components.
This is in a favorable direction for market valuations. My analysis uses the long-term Real GDP trend of 3.15% and adds the 12mo Trimmed mean PCE to produce the Market Capitalization Rate(MCR). This value then is calculated with today’s release to be 4.85%. This then becomes the means of valuing whether the market is over/under priced all things being equal and the same can be said of individual stocks and bonds.
For Treasuries this becomes a simple calculation. One simply takes the 10yr Treasury Yield which today is ~3.46% and by comparison it is simple to see that the general economy should produce a higher return than 10yr Treasuries. The lower 10yr Treasury Yield is because of the risk investors perceive in alternative choices.
There is not enough space this email to detail the analysis of the SP500, but mean estimated earnings are currently $64.50(3Q09) and as I write this the SP500 is priced at 1030. The Earnings Yield of the SP500 is calculated simply by dividing est. earnings by the current price or $64.50/1030 = 6.26%. This is a simple methodology and all the inputs can change over time, but the process produces a relative return comparison that is simple to use. To convert this into a estimate for the SP500 price target one divides the SP500 Earnings Yield by the MCR, 6.26%/4.85% = 1.291 or 29.1% higher. This means that all things remaining equal the SP500 has the capacity to rise to ~1330 IF earnings were to be at median level today and IF investor psychology normalized. Note: If inflation changes so does this number which can dramatically change market pricing. Lots of “IF’s” here but this is how the market works. We can only make estimates and can never make guarantees.
The calculation uses a normalized or mean earnings estimate because the basic assumption is that the companies in the SP500 are expected to recover as they have since 1930(79yrs of economic and investment history). There is nothing that I can see in our current situation that would suggest that a recovery would be impossible. If something should suddenly become apparent that our Free Market Economy had been injured by unthinking government action, then we would have to revisit all assumptions. But, even with all the issues being discussed today which seem potentially injurious to our economy, history shows that sparring political parties generally compromise without major damage to our economy.
This Dallas Fed release makes allocation to stocks and corporate bonds quite favorable at this time.
Disclosure (“none” means no position):