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How to value the S&P 500 like an expert in 3 easy steps
Valuing the S&P 500 is integral to successful global large-cap stock market value investing.
It’s one of the first modules we teach in the Value Investor School because the S&P 500 is the most followed and written about stock market index in the world.
That makes it the simplest index in the world to research and invest in.
Just look at the top ten largest stocks by market capitalisation (at the time of writing).
Market capitalisation refers to the total dollar value of ALL the company’s shares combined.
It reads like a who’s who of the most well-known global businesses:
Alphabet Class A (GOOGL)
Alphabet Class C (GOOG)
Berkshire Hathaway Class B (BRK.B)
UnitedHealth Group (UNH)
Johnson & Johnson (JNJ)
Exxon Mobil (XOM)
The top five of these stocks represent 20% of the total value of the S&P 500 and some of these names are in the financial press on a daily basis.
So it pays to get to grips with the value of the S&P 500 on a regular basis to either invest in it directly with an index fund or to get a sense of general market valuation.
The importance of valuing the S&P 500 from a value investing perspective
Type the words stock market into your browser or favoured social media channels and you’re bombarded with a thousand opinions on what you should or should do with your money. Sometimes you’ll get stories of the latest stock to collapse in value.
When we come across headlines and news articles from the financial press, they almost always sensationalise the truth as to what is happening to stocks day to day.
How the stock market works in context with macroeconomic events, and how your individual stocks can be affected by rising or declining market values is an important skill set to develop.
The constant wall of noise can be confusing as we’re drawn to seek out ‘expert opinion’ in times of uncertainty whether stocks are rising or falling.
There must be an intellectual safety net out there somewhere.
Luckily, the value approach is an intellectual safety net based on your own balanced, independent research. It is a far better judge as to what to do in any given market scenario than the noise machine from Wall Street.
Financial publications get paid by making you click through to their articles.
Pay yourself first with underpriced value by determining when the S&P 500 is undervalued.
#1 Find out the PE ratio of the S&P 500
A lot of investors balk at the idea of valuing stocks with the PE ratio relegating it to a prehistoric has-been.
The manipulation of earnings by unscrupulous managements and the sometimes lumpy earnings successful businesses produce, yo-yo-ing up and down like no tomorrow, make it difficult to get an accurate valuation of a stock or index based on its earnings.
Or so they say.
Yes, there is also a heavy earnings bias toward the largest capitalised stocks; much of the earnings are concentrated in the top 10 stocks due to their enormous size and global sales.
But I’ve got news for you: nothing is ever perfect in the world of investing.
Successful investors understand that reasoning based on the most accurate information available is better preparation for successful, profitable investing than relying on the opinion of almost everyone.
The number one resource I use for finding out the PE ratio of the S&P 500 is multpl.com, from Rober Shiller, Professor of Economics at Yale University.
When you click through you’ll get a nice chart showing the PE ratio of the S&P 500 from about 1870 to the present day.
#2 Compare the current PE ratio of the S&P 500 to the historical PE ratio of the S&P 500
One thing you’ll notice from the chart is the wild swings in value the S&P 500 has had over the years, especially since the massive liquidity manipulations starting in the 1980s.
Ultimately, your task is to compare the current PE ratio to its historical value.
You do that by noting where the S&P 500 PE ratio is now and where it has bottomed in the past.
The last bottom was in 1980 at 7 and the PE ratio has since made only two major bottoms of 17 in 2006, and 14 in 2011/12.
Put another way, the S&P 500 PE ratio has been bottoming at around 15 over the last 40 years.
Pro tip: on each of those occasions, the Federal Reserve put a floor in and artificially inflated the value of the S&P 500 with quantitative easing and cutting interest rates.
#3 Decide whether the S&P 500 is overvalued, undervalued, or at fair value
For simplicity, I use three gauges of stock market valuation to help them value stocks:
You can see why it’s a popular method.
But you can’t get to decide where the S&P 500 is on the value gauge until you’ve done the work and the work tells us that as of the publication of this post, the PE ratio for the S&P 500 is 20 which means it is around fair value.
Why fair value?
Remember the average PE ratio bottom range of 15-17, that is the undervalued range.
It makes sense that 18-20 is fair value range and anything above 20 is overvalued.
Why is 20 overvalued?
Because a rock solid principle of value investing is that we buy stocks and index funds at a discount to intrinsic value (fair value).
One thing to note is that these ranges are not absolutes. They change with economic times such as the recent central bank and government manipulations of stocks since the 1980s.
Ranges play an important role of placing the value of the S&P 500 in context to historical values.
For even greater context, the S&P 500 is heading towards undervalued because the Federal Reserve is in a monetary tightening cycle (raising interest rates and shrinking its balance sheet) and the US is already in a technical recession.
The White House and The Federal Reserve have both tried to redefine what a recession is for political reasons but the truth is that GDP has declined for two back-to-back quarters in a row.
The Federal Reserve also strenuously maintains that rates will rise well into 2023 and well-known financial institutions predicting a global recession in 2023.
Based on the history of how stock market prices perform under similar conditions, the S&P 500 is likely heading lower.
How much lower?
That said, you’re job is not to second guess the President, The Federal Reserve, or even where stock prices are heading in the future.
From a value investing perspective, you’re simply defining what the value of the S&P 500 is now whilst taking into consideration the macroeconomic environment of the global stock market.
Publicly available interest rates and GDP data help you with this task.
Over time as you regularly interpret financial markets news flow within the context of a value-first approach, you’ll develop a deeper understanding of how the stock market actually works not from a day-to-day perspective, but from a long-term, low-risk perspective that most market participants do not consider.
You have my permission to take ownership of your own financial success.
Need some help with becoming a smarter investor?
A value-first approach to investing creates a mind free of distractions that’s hard to beat.
Sometimes value investing can still seem bewildering given the never-ending stream of headlines and financial jargon, especially in times of uncertainty.
You may even have struggled with some of the terminology in this post.
The good news is that you do not have to choose between a financial dictionary and interpreting 1000 opinions a day to become a truly successful, long-term investor.
You can use a value investing framework that respects your time, common sense, and appreciation of what actually matters in financial markets in plain English.
If you want to learn more about making successful value-orientated investments, check out the online stock market investing course.
The post How to value the S&P 500 like an expert in 3 easy steps first appeared on Wealth Accumulated and was written by D J Thomas .