October 30, 2013

Kass: Fair Market Value Update 2.0

"We believe that short-term forecasts of stock or bond prices are useless. The forecasts may tell you a great deal about the forecaster; they tell you nothing about the future."

-- Warren Buffett's letter to Berkshire Hathaway (BRK.A)/ (BRK.B) shareholders, 1980

Forecasting prospective market levels out 12 months is an imprecise art form that requires probabilistic decision making, using imperfect information about an inherently unknowable future. Forecasting market levels out beyond 12 months is, to me, more a function of one's philosophy than an investment prediction.

But try we must (especially over the next 12 months) even despite The Oracle's protestations. It has been nearly nine months since I last published my estimate of the S&P 500's fair market value, but I am going to give it a go again this morning (with the insistence from subscriber Renato, who sent me a nice note recently).

Remembering the phrase that if you have to forecast, forecast often, I will attempt to update my fair market value every month or as circumstances change. Early this year, I expressed the view that a domestic economy incapable of reaching escape velocity would produce a challenging earnings landscape. This, to me, represented the principal enemy to the U.S. stock market for 2013 and formed the basis for my four core scenarios (economic, earnings and market valuation) that yielded my fair market value calculation.

Anemic top- and bottom- line growth in corporate sales and profits were by no means the only factors that contributed to my valuation concerns this year as was the growing evidence that aggressive monetary policy is losing its effectiveness and that our leaders are failing to address our deep-seated fiscal issues. Instead (and out of necessity), our authorities placed ever more pressure on our monetary policymakers to bear the responsibility of bringing our domestic economy out of its doldrums. After nearly five years, the results barely met a passing grade and uncovered the depth of our structural headwinds that have been ignored for so many years (e.g., disequilibrium in the jobs market, screwflation of the middle class, financial repression penalizing the savings class, etc.), and once again, the Fed has overestimated U.S. economic growth and the positive impact of trickle-down economics (through the lifting of asset prices).

Forecasting is the art of saying what will happen and then explaining why it didn't. While my fundamental observations (and headwinds) still seem materially correct, my assumptions for a contraction in P/E multiples were wrong-footed as were my market conclusions and S&P price targets.