So What Is The Right Proportion?

So what is the right proportion? WRT "proportion," I am referring to the appropriate fall in asset prices given the decline in fundamentals. To answer that question, I think it is somewhat helpful to reverse engineer a fair market value for the stock market based on the fall in corporate revenues (and profits), and the fact that the market was overvalued at the peak (ie. risk premium was way too low).

To do this I work off the following assumptions. Public company revenues have fallen somewhere between 20%-30%. Public company profits have fallen somewhere between 15%-25% (stripping out financial write-offs). If I adjust for the undervaluation of risk at the peak of the market, and multiply those declines by say a factor of 1.7x, then I think a case could be made that S&P 500 fair value is somewhere around 1040. Peak S&P 500 = 1576. Decline in profits = -20%. Multiplier applied to decline in profits given the undervaluation of risk = 1.7x. Calculation: -20% x 1.7 = -34%. 1576 - 34% = 1040. All this is saying is, that the market should probably have only fallen about 34% given the decline in fundamentals. The fudge factor, of course, is the risk adjustment multiplier, and its level all depends on how overvalued you think the market was at its peak. And, of course, markets overshoot (both up and down).

The tricky task is in our business is marrying the economic fundamentals with an appropriate multiple for asset prices, adjusted for a reasonable risk factor. Previously, I looked at fair value for the market from a bottoms-up perspective (looking at normalized earnings) and put it somewhere around 900-950 ($60 normalized earnings x 15x = 900). What is confusing me at the moment, however, is determining whether to apply a higher or lower risk factor to the future (ie. what multiple to apply). In many ways I can see where a higher risk factor should be inputed (greater chance for fiscal and monetary policy error, higher taxes, lower consumption, structural shift, etc.), but in other ways I can see where a lower risk factor is warranted given that we have overshot fair value.

All of this speculation is independent of what actually happens in the future, which will tell us (in hindsight) what side of the risk factor I should have fallen on.