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Implied Market Premium

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By jackcrow
July 29, 2005

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Just finished channel surfing and CNBC was squawking about a four-year high mark for the S&P500. Knowing that not all highs are created equal and being contrarian suspicious of any "significant milestone," I thought I would run today's numbers through Dr. D's. implied market premium calculator.

At close today the implied market premium is 2.11%

What does this mean?

If we work backwards from the often quoted 11% return of the market we 1st subtract out inflation, then we subtract anticipated growth, what we are left with is "the market premium".

11 - 4.5(long bond as proxy for growth) - 3(a rough mean proxy for inflation)= 3.5% is the premium Mr. Market is suppose to cough up.

If we rebuild our number 4.5 + 3 + 2.11 = 9.61%

How do we interpret this? Simply put, if you are planning on garnering an 11% return from the market you are more than likely to be disappointed. The market itself is telling us that its priced to return 9.6%

In real world terms how do we apply this?

If our goal is to beat the market, not a specific number, then any investment that should return more than 9.6% would be a better investment.

We also might want to adjust down any growth estimates we are using in our models as we evaluate companies.

What else does this tell us? It tells us that there is a price premium built into the market. Think in P/E terms, this would be a higher P/E. The market is pricing in a premium. What this indicates is hard to forecast with precision. We do know that the majority of the buyers in the market are willing to pay a premium to own a piece of the market.

Sometimes paying a premium looks stupid today, but looks like a great bargain a year or three from now. Sometimes paying a premium is just paying extra money for no significant gain. With this metric sometimes it's an indicator of an overheated market.

Only time and more data will tell.

jack


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