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By This Measure the S&P 500 Looks Cheap Right Now

By Jay Jenkins – May 21, 2015 at 1:52PM

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Could the S&P 500 hit 3,000 by 2020?

This month a prominent investment management firm published a report arguing that the S&P 500 is cheap. Really cheap. Cheap as in it could rise by 50% or more over the next four to five years.

What does that mean for you? Let's find out.

Using GDP to gauge the S&P 500
Cumberland Advisors, the $2.3 billion firm behind the analysis, began the report by studying the ratio between U.S. gross domestic product and the S&P 500. The theory is that U.S. markets should reflect, over the long term, the rise in productivity of American businesses.

Cumberland reported that the ratio hit its low in the early 1980s, with the S&P dipping as far down as 31% of U.S. GDP. The long-term trend would have put the S&P at 62% of GDP, meaning that the bottom was two standard deviations below the long-term trend. 

These kind of swings are common historically. The market boom of the late 1920s pushed the valuation well above the trend. Likewise, the market lows during World War II were well under the expected trend value. That's the nature of group psychology as reflected in the stock market. People tend to overreact to both the highs and the lows.

Since the lows of the 1980s, the S&P 500 has tracked increasingly higher in terms of GDP. Today's S&P-to-GDP trend, again according to Cumberland's analysis, puts the market at about 95% of GDP. The current level is actually above that trend, though, at 105%. 

Shouldn't that suggest the market is maybe a little expensive, or at least pretty close to fair value? According to Cumberland, this is actually cheap, and the reason is globalization.

"The trend is clear, and it is up"
Since that low in 1982, the percentage of profits at U.S. companies originating in foreign markets has risen from just 10% to 30% today.

Those foreign profits won't show up in domestic GDP figures. That means the context of the S&P-to-GDP ratio has changed. The S&P should trade at a higher ratio to reflect those profits that won't show up in the GDP calculation. The historical trend line will naturally undershoot today's reality because this shift to globalized profits is a relatively new phenomena. 

In other words, the S&P 500 looks cheap. David Kotok, the report's author and chief investment officer at Cumberland, went so far as to say that while there is always uncertainty in forecasting how markets will behave, "the trend is clear, and it is up."

No model is perfect. Here's how this forecast could be wrong.
This is a very clever analysis, and it does seem to indicate a continuation of the current bull market. However, never forget that "the trend is your friend ... until it bends at the end." Some assumptions built into this model could prove false.

First, and hopefully most obviously, an unforeseen event could send the U.S. into recession. That would obviously slam the brakes on the upward trend line.

Global GDP is already struggling as the Chinese economy slows and Europe deals with its own serious problems. Those events will have a greater impact on American companies than ever before.

Likewise, this analysis ignores potential changes in the dollar's strength, inflation, interest rate changes (domestic and abroad), and virtually every other macroeconomic factor. It's pretty narrowly focused. 

What's the takeaway?
Right or wrong, this report does provide useful insights into today's investing world. I see two clear-cut takeaways. 

Investing in U.S. companies is, like it or not, an indirect investment in the global economy. As noted, today's U.S. corporate profits are about 70% domestic and 30% international, and the trend is moving toward increased reliance on global markets.

Second, I think it also points to the fundamental improvement in the economy since the Great Recession. The market looks healthy by many measures -- profits are up, domestic productivity looks increasingly strong, inflation remains in check, and the stock market continues to rise.

A return to normalcy does include the occasional bear market, which is just fine for long-term investors. So enjoy today's bull run, but let's not forget that pullbacks are inevitable, and they are buying opportunities.

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