Editor's Note: As an emerging-markets banking analyst, James Kostohryz has firsthand experience of banking collapses and their subsequent resolutions in Mexico, Argentina and Southeast Asia. Since leaving his position as Head of International Investments at Brazil's Banco Pactual in 2000, James has worked as an independent trader and investor.

Introduction

Some prominent commentators are warning that the S&P 500 index will collapse far beyond the recent low of 667, with some suggesting targets as low as 350-400, which would represent a decline of 41% - 48% from current levels. Other prominent commentators are predicting that the market will bottom out at or around current levels, and are saying that now is a great time for investors to buy. Given these conflicting predictions, and the current dire situation in the economy and financial markets, investors are understandably confused and fearful.

In life, when you're lost, and need to make choices about where to go and how to get there, in order to make a good decision that you can feel any degree of confidence about, it's useful to have a map so that you can determine where you are currently.

S&P 500 Index Valuation Models

In order to know whether stocks are expensive or cheap, it's useful to have a good idea of how expensive and/or cheap they've been in the past under particular circumstances.

There are myriad ways to analyze the value of stocks over time: trailing PE ratios, forward PE ratios, Tobin’s Q, P/BV, dividend yields, dividend discount models (DDMs), the “Fed Model,” earnings yield gaps, and many more. I personally track dozens of valuation methodologies and have developed several of my own.

Below, I'll present a model that applies a widely followed valuation methodology developed by Yale Professor Robert Shiller. Afterward, I'll offer one of my own proprietary models.

An S&P 500 Index Valuation Road Map: Robert Shiller's PE10

One valuation methodology that's received a good bit of attention recently has been Yale Professor Robert Shiller’s PE10. PE10 is a methodology that calculates the PE of a stock or an index based on taking the current price and dividing it by the average of the respective earnings for the past 10 years, adjusted for inflation. This methodology provides an estimate of value based on historical “normalized” earnings.

Making a calculation of normalized earnings is important because a company’s value isn't based on its earnings in any given year, but is based on its capacity to generate earnings many years into the future. Thus, it would be inadvisable to take the earnings of a company or index in boom times and use that as the basis for a valuation. Doing so ignores the fact that there will be recessions and bad times, and we need to have an idea of a company’s earnings power over an entire cycle (or several cycles).

Similarly, it would probably be foolish to value a company based on the earnings it generated during a recession because recessions don’t last forever; we need to form a reasonable expectation of what a company, or an index of companies, might be able to earn over an entire earnings cycle.

Thus, Professor Shiller applies the PE10 methodology to a powerful database of information that stretches back to 1871. In the graph below, I construct a very simple model, based exclusively on Professor Shiller’s methodology and data.



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