It is likely that further gains in the market will be muted or even unlikely based on multiple valuation measures. We look at several in this post. As a matter of reference these observations are discussed in detail at our latest Investment Survival Workshops. If you have never been to one, they are worthwhile( no one has ever rated them less than good or excellent) and if you have attended a workshop in the past, we update these events with current and timely topics so please join us for the next one. We keep a schedule of the upcoming workshops at workshops.saxangle.com
Based on the Gordon Growth Model, also commonly referred to as the dividend discount model, the market is slightly undervalued. The dividend discount model (DDM) is a method of valuing a company’s stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. Based on our analysis of the S&P 500, the market should be trading at around 2156, about 2.9% higher than Friday’s close of 2094.11
Based on the Gordon growth model the market is fairly valued or slightly undervalued by 2.9% if you buy into low-interest rates as far as the eye can see. This is a simple formula taught in business school with some very big and uncertain assumptions.
The variables are: 
In applying this to the market as a whole, the dividends are the combined dividends of the S&P 500 members, the largest companies in the U.S. Because the S&P 500 is a float adjusted market cap weighted index, the dividend Apple pays is weighted greater than the one Microsoft pays, for example since it now has a much bigger market capitalization.
There is no debate about the this top number as it is just the sum of the dividends paid by the members of the S&P 500. The S&P 500 is yielding 1.93% or paying $40.81 in dividends. Consensus is that dividends can grow about 5.7% next year or $43.14. This is the numerator. So far it’s just math, not a lot of assumptions.
Now for the tricky part, the denominator. My return expectations or cost of equity capital aka discount rate is 7% (that might even be too high in an ultra low rate environment). Historically this number has been higher perhaps more like 8-8.5% but I think those days of double-digit market returns (the 1980s-2000) are an anomaly, not the norm. Following the Gordon Growth model, next year’s dividend is divided by the difference between the required return minus the long-term dividend growth rate. US companies have been growing dividends at about a 5% rate for a long time. When the economy turns down, public companies cut costs, layoff employees, and delay reinvestment but most keep the dividend sacrosanct. The numerator is next year’s dividend of $43.14 divided by the denominator of 2% (7%-5%) resulting in an S&P 500 of 2156.81 or about where it is today.
Of course this is only one way of looking at market valuations. If it were as cut and dry as applying a simple math formula, your accountant would be your investment genius and everyone would have more or less the same investment returns. The Gordon Growth model is not even the most widely used measure of market valuation. This chart from JP Morgan Private Wealth group compares a variety of the best known market multiples.
By these standards the market is overvalued on many of them but not greatly when you measure it against the 25 year comparison. These ratios and the Gordon Growth model are all math based but we know that the market is much more complicated than a math model. An entire new field of economics called Behavior Finance has evolved recently based on the realization that human emotions and social interactions have a much greater impact on stock market prices than previously understood. In fact Robert Shiller won the Noble Prize last year for his work in the field. The following chart appealed to me because it wasn’t based on math but on the past outcomes of economic cycles and their resultant impact on capital markets
When we do the workshops this is a question I always make the audience answer. After all everyone should have an opinion about what phase of the economic cycle we are in based on their own observations. I’d love to see your comments about which phase you think we are in.
That gets us to the bottom line as accountants like to say. I have to agree with the Goldman Sachs projection of market returns published in May of this year on Bloomberg. It will be tough sledding to get outsized returns from this market now. You will be pretty much be getting dividend yield from here on out. So keep that in mind that historically 44% of all market return has been from dividends. That doesn’t mean though that individual stock pickers can’t do well. In fact they should start outshining the indexers based on this analysis.