Perhaps I'm reading this wrong, or am lacking some understanding, but a Morningstar Chart purports to show that the universe of stocks they cover is now about 3% undervalued. This compares to about 6% over-valued in February through May, suggesting a 9% improvement in valuations since then. Since valuations are governed primarily by two components, overall interest rates, and growth (earnings) prospects, it begs the question: Since neither has improved (i.e. earnings growth is reportedly stable at best, and interest rates have moved up), how do these factor into their model?
Obviously, overall values have dropped over this period, but looking at the S&P 500, this can only account for about 6 or 7% of the change, without considering the (negative) change in interest rates, and any diminution of growth prospects.
Maybe it's just me, I might be missing something.
The Confused Capitalist
6 comments:
You are missing something fundamental and elementary. Valuations are comprised not only of interest rates and earnings growth, but also of the equity risk premium. After all, the discount rate is the risk-free interest rate PLUS the equity risk premium. The increase in the equity risk premium is what has led to cheap valuations.
I'm not sure I am missing what you say.
An increase in the equity risk premium means that prices have to fall to become undervalued. Although this has happened, it hasn't happened to the extent of the underlying rise in the Fed rate (using the rise as a very rough proxy for the change in the equity risk rate).
No, I think the change has to have come from a projected increase on the earnings side. That's the only thing that makes sense to me - it's just that I don't think earnings are going to be accelerating. Hence my confusion.
JW
You should not be using the Fed Funds rate as the proxy for the riskless interest rate. Remember that equities are infinite-lived instruments, so the proper discount rate is the 10 or 30-year Treasuries.
Those certainly have not changed much over the last 6 months. The difference is explained by the equity risk premium. Earnings expectations, as measured by IBES, have increased, but not enough to explain the change in stock price levels.
OK, I was taking a short-cut (using the short-term Fed rate). My point was that I didn't miss any change in the equity risk, because it was going the other way to the valuations.
Since the equity risk has INCREASED, that cannot explain a change from overvalued to undervalued. IF all other things are equal, an increase in the equity risk premium means that a static stock price becomes more richly (ie over) valued. (Remember a higher discount rate = lower valuation)
I didn't realize the earning projections were accelerating over May estimates.
JW
Actually, holding everything else fixed, an increase in the equity risk premium implies CHEAPER or LOWER stock prices, which is what has happened in the last 3 months.
I'm pretty sure we're saying the same thing now. Perhaps I'm not expressing myself well.
If the equity risk premium increases, but the market price of the security remains the same, then it isn't a good a deal as before. i.e. possibly over-valued.
JW
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