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What Is the Fair Value of the S&P? Ask Baa Long-Term Corporate Bonds

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Here's the math: Calculations suggest the stock market needs to go up 33% before it hits fair value.

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While there are a wide variety of corporate bonds, thanks to FRED we have long term data on AAA and Baa Long Term Corporate Bonds going back to January 31, 1919. Which one should we use? There are only four AAA companies left (Microsoft (NASDAQ:MSFT), Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ) and Automatic Data Processing (NASDAQ:ADP)). So Baa debentures income flows would seem to match up with the S&P better than the AAAs.

The average yield for Long Term Baa Corporates is 7.06%. Stocks' earnings yield over the same time period is 7.43%.

Therefore, stocks have had an average earnings yield of 0.37% more than Baa Corporate Bonds. This seems to be a nice match. Let's go to the chart.



You can see there was a very wide divergence from stock and corporate bond yields from around 1939 to 1958. However, when debt yields went up in the 1960s and 1970s earnings yields followed suit. And when debt yields came down from their early 1980's highs, stocks were allowed to trade at below their historical average earnings yield.

So what is the final answer?

Using the current Baa yield of 4.48% and adding a 0.37% historical average premium spread gives us a fair value earnings yield of 4.85%. The calculation is 87.92 (earnings) / 0.0485 = 1,812. This method would suggest that the S&P would need to go up by a third to hit fair value.

So, in summary, we have determined that 1,812 is the current fair value for the S&P. What is interesting is the 252 Daily Rate of Change decline on the 30 year bond yield indicator suggested the S&P could go to 1800 as well. As Baa rates change, the fair value calculation will be modified accordingly.

But as of right now, it adds solid fundamental evidence to compliment the many quantitative indicators which are bullish on stocks.
No positions in stocks mentioned.
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