“The Market is Significantly Undervalued”
January 13, 2009
Brian Wesbury is Chief Economist at First Trust Advisors L.P., a financial services firm based in Wheaton, Illinois and serves on the Board of Advisors to First Trust Capital Partners, an affiliated private-equity firm. The Wall Street Journal ranked Mr. Wesbury the nation’s #1 U.S. economic forecaster in 2001 and USA Today ranked him as one of the nation’s top 10 forecasters
in 2004. Mr. Wesbury writes frequently for the editorial page of The Wall Street Journal and is the Economics Editor of “The American Spectator.” He is also a frequent guest on Fox, Bloomberg CNBC TV and BNN Canada TV.
We interviewed Mr. Wesbury on January 12, 2009.
At the end of last year you wrote that stocks were “dirt cheap,” with a fair value of the Dow at 15,000. Can you please walk through your logic behind this estimate?
We use a capitalized profits model. This has several components: measuring corporate profits, discounting them to determine a present value, and then translating this to a market level. I will go over each of these steps.
First, we do not use reported earnings as a measure of corporate profits. We use the income that corporations report to the IRS, because we believe this is the most conservative approach. No corporation is going to pay taxes on profits it has not really earned.
Normally, we would use the 10-year Treasury rate (currently 2.35%) as a discount rate. But, because we believe 10-year Treasury bonds are now overvalued, we use a rate of 5%, again to be conservative. This produces a value of 1494 for the S&P 500 or approximately 15,000 for the Dow.
To suggest that the market is fairly valued now, you would need to assume either profits would fall by 40% or that interest rates would quadruple to 8.5%. These are extremely significant events and, in my mind, highly unlikely.
Our model is very robust and we are confident in our belief the market is significantly undervalued.
One of the components in your valuation model is the translation of the capitalized profits to a market level. Can you explain in more detail how this works?
As you say, when we capitalize profits, it gives us a value, but that value does not correspond to a level in the S&P 500 or the Dow. In order to make that translation, we need to look at historical data to determine the appropriate relationship between capitalized profits and market index values.
We have a historical database that goes back to 1953. We look at quarterly data (capitalized profits and market index levels) over this 56 year period, and we take an average value to do this translation.
In other words, our model adjusts for periods of extreme under- or over-valuation in the markets.Display article as PDF for printing.
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