Tom A's Stock Picks

Determining Market Level - How high is the S&P?

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My approach to determining market level relies on computing a ratio of the S&P to GDP and tracking its movement over time. Using quarterly data from 1990 to the present, I compute the ratio, assume it is lognormally distributed, and express the relative level as a percentage from 1 to 100. Here are some results of this exercise:

As an example of how I apply this line of thinking, on March 17, when the S&P stood at 1,276, I felt the market was at 48%, right around the midpoint. To be comparable to the low point in 2002, it would need to go down to 1,100, another 12%. Guessing that 1,100 was the minimum prospective lowpoint, I went all in because I could handle another 10% drop if it occurred. At Friday's close of 1,425, the S&P is above its midpoint, at 63%, by no means at nosebleed levels. A really sickening bottom could see S&P as low as 800.

I use this method because it walks around the issue of profit margins. Those who tell you the market is cheap relative to its earnings neglect to add that profit margins have recently been at historical highs and have a long way to drop. Over the long run, when stock prices are high relative to GDP, it reflects that business prospects are good and stocks represent a valuable claim for a slice of the pie.

Also, the 2002 low point was not really all that low. Remember how the Fed kept cutting interest rates? This intervention was successful and prevented the market from reaching lows comparable to the early 90's. So we really haven't seen a serious bear market yet this century. If Stagflation develops and leads to a combination of low profit margins and low P/Es, it could be a long way down. On the other hand, S&P 2,000 is reachable - if we avoid a serious recession and solar/alternative enegy develop rapidly enough to ease the pressure from the cost of oil, new era thinking could set in.

Tom