Standard and Poors' 500

With S&P500 breaking records after records, one must wonder if we are nearing the peak, and if so, when will it burst and when it does, how bad would it be? No one can claim to know the answer of these questions, but we can have a logical approach to it.

The Standard and Poors' 500 has the following describing the composition of the index:
"The S&P 500® is widely regarded as the best single gauge of large cap U.S. equities.  There is over USD 5.14 trillion benchmarked to the index, with index assets comprising approximately USD 1.6 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization."

Even though it does not represent the entire market, but it is probably close to as best as you can get, not so because the composition is accurately representative, but because of its volume and how it is perceived. In the world of finance, how one thing is perceived matters more than what it really is, especially in valuation. After all if no one wants your painting it doesn't matter if you are Picasso, right? We will treat S&P500 as representation of the market from here on.

The valuation of an financial instrument, be it a stock, a bond or an index, based largely on two things: intrinsic value that focuses on the long term capital returns, and short term extrinsic value based on how volatile and risk factors perceived to be associated with this instrument. For the latter one, human emotion has a much larger influence on it, and also because the intrinsic value is focused on longer term, and things may very well changed over time, this human emotion part on how things are perceived becomes quite important, more important than many of the fundamental analysis, value driven investors think.

Now that we have broken up the two important category, let's examine each of them. I will attempt to focus on established methods while not too much relying on any particular models to get a balanced view. Let's start with the big picture. Where are we at now?

There is a well publicized view from presumably Warren Buffer's view of stock valuation, noted in this business insider article: Warren Buffett Once Said This Was The 'Best Single Measure' Of Stock Market Value, in which this graph is particularly interesting:

And that was in January. The market has risen much since then. so what does that tell us? Fundamentally, at least from the metrics described in the article, the market is in lofty valuation, so much so that traditional models no longer apply. Or is it? This model of representation forgets about the fact that prior to 2008, there was minimal Federal Reserve intervention, in particular the Quantitative Easing (buying bonds and asset with nothing but money printed) that we now all accustomed to. How much does that affect the valuation? If we can subtract that influence, can we get a better picture of where we may be now? From the Economist article in the link, the balance of the Fed is about $4 trillion, plus $85B-$75B per month. There has been some adjustment, and supposedly the number is being tapered down month by month. So let's put the number at $4.5T for the sake of simplicity. This number is pretty accurate according to Yahoo's news on Fed's decision to continue winding down the bond purchase, of $4.4T.

Technical Analysis verses Fundamental Analysis

One can view the market as a complex man-made system with evolving dynamics which are intertwined with each other. Unlike natural system however, attempt to model it is can be more difficult than existing systems in nature in the way that human is involved as part of the dynamics, and thus a seemingly successful model may soon be exploited and be factored in as another input dynamics, thereby altering the whole system.

There are unlimited ways to cut through the mustard, but in general we can categorize the majority ones into two: technical analysis and fundamental analysis. I would consider market emotion as part of TA. Some count it as the third one. Anyway here is what I think of these two type:


For a graph technician who works in the field of technical analysis, he does not need to know what the company, which the stock represents, does. In fact, it is better not to know, because the extra information will skew his judgment. In performing TA, the technician would mainly consider historic trade transaction data consisting of price movements and volume. And that's it. There are a lot of derived data created from these pair, the most famous being the candle sticks, moving averages and stochastic oscillators, depending on your taste, but fundamentally, these bells and whistles are all coming from these two simple entries: price and volume, on different horizon or time frame.

Now arming with these tools the technician can plot support and resistant levels, determining trend and then make his projection -- at this point this is really more art than concrete mechanics.

Comparing to TA, an analyst performing fundamental analysis has a lot more data to consider. Let me throw in the important ones: company past earnings, debt/liabilities, cash flow, market outlook, credit and the list goes on and on. To put a price on it, there are a few generally accepted models, like the discounted cash flow and the discounted dividend model, with the premise that assuming the company will exist forever, what is the present value of the company considering all the future revenue? There are many weak points in this assumption, but let me point out the one that academia likes to avoid: in calculating the discounted future value, how do you know what the discounted rate (most use the inflation rate) is? Usually they would resort to historic average, but is that it? Can't I just take the historic average of P/E ratio of S&P and assume the board market will drift back to this mean, assuming that these are cointegrated? Wouldn't life be much easier then, ha. But even assuming the rate will remain relatively constant, and that the company would not deviate from its past performance too much, this projected price is only the backbone of price estimation. Overloaded with all the information from earning reports, the analyst must decide and pick the important ones to calculate how much the company is worth based on his projection from the mountains of data. Popular metric includes Return On Equity (ROE), Economic Value Added (EVA) and Price per Earning ratio (P/E), comparing to the company's peers in the industry. These are all levers and knobs to adjust the projection. Unlike TA, these are actually based on sound (at least on the surface) financial theories to calculate how much a company is worth.

In the end as you may have figured, it is all approximation and guess work. I would not say this is logical guess work because you cannot prove any of the above really work. Let's not inflate and rape the rigor of logic.