Reducing Our Stock Market Forecasts

At the end of 2021, we set out our projections for the stock market in 2022: 5,250 for the S&P 500 and 40,000 for the Dow Jones Industrial Average. Those projections were based on our expectations for both profit growth in 2022 and the yield on the 10-year Treasury note. At that time, given interest rates, the US stock market was still under our estimate of fair value.

This is no longer true. Given the surge in long-term interest rates this year, the US stock market is now fairly valued for the first time in over a dozen years, dating back to the Panic of 2008. During many of these past twelve years, with the US stock market well under fair value year after year, we often lifted our year end forecast during the year.

We use our Capitalized Profits Model to assess fair value on the stock market. The model starts with the government's measure of economy-wide corporate profits and uses the yield on the 10-year Treasury Note to discount those profits.

The yield on the 10-year Treasury finished last year at about 1.5%, which made the stock market look extremely attractive and undervalued. But to be cautious – and because we knew the 10-year Treasury yield was being held back by excessively accommodative Federal Reserve policy – we used a 2.5% yield to discount profits, instead. Using a 2.5% yield suggested fair value for the S&P 500 was 5,250, which became our forecast for the market at the end of 2022.

But here we are in early May and a vicious sell-off in the bond market has pushed the 10-year yield to 3.1%, substantially higher than the end of last year and above our 2.5% estimate. This higher yield makes a world of difference in how our model sees the stock market. Using a yield of 3.13% and fourth quarter profits suggests we were already at fair value as of Friday, with the S&P 500 closing Friday near 4,100.