The question arises after the New Year, ‘How did the market do?’ followed by, ‘How do you think 2012 will look?’. Both are tough and very applicable to almost every portfolio. Rarely, do you find an investment process that does not take into consideration what the future will bring.
The easy answer would be to pontificate about some obscure economic condition such as Greek debt credit default swaps followed by high degrees of waffle and disclaimers; none of which is very helpful in making decisions regarding a portfolio.

During 2011 the market started at 126.25 (IVV) and ended at 125.96. (IVV is the iShare that represents the S&P500 index.) This represents a 0.3% decline, or a flat market. The movements throughout the year were robust with 100, 200 and sometimes 300 point days, both up and down. In the end, the market moved violently sideways.

The market was full of uncertainty, both domestically with a quarreling whining Congress, and abroad with European governments that couldn’t keep their credit cards in their wallets. For the market to end up close to where it started actually made total sense, because it ended up very close to fair value. It is neither a premium nor a discount but, very close to reflecting the actual profitability of the market’s fair value.

In earlier posts you have heard me talk about fair value. This is a measurement of how well the current stock price represents the true economic value of the company when profitability and market position (product or service based not stock market) are taken into consideration. Why should you care about fair value?
With the uncertainty of 2011 and the violent up/down market movements, an investor could get quite worried. However, if an investor watched the movements of the market and realized they were basically around fair value, they are much less concerning. After all, why should the market move up or down from fair value if it is unsure of the future?

If you are investing money in the stock market you want to be reasonably sure that you are paying a fair price and can expect a favorable return over the time that you hold the stock. If you buy stock at a premium (over valued), the chances that you will see an increase in value are less than if you bought the stock at a discount (undervalued). Also, you may be buying into the market as it is starting to reach the peak. Now there are mountains of studies about what constitutes fair value and how it might apply to stocks differently in various markets. But, that is for another discussion. Right now we want to see what the future may hold for the markets so let’s keep it focused.

Chart A below shows the market (S&P500 Index) represented by the red and green line. Fair value is marked by the white horizontal line at 117.

For a comparison to the DOW that would be around 11,366.

There are several other lines on the chart that deserve some explaining and recognition. The red horizontal line represents a level of 120% of fair value, or 20% over fair market value, a premium situation. This is important because usually when a stock becomes that far overvalued by the market it has a tendency to return back to fair value (white line) rather than continue increasing in price. The higher the stock moves above fair value line, the higher the probability that it will slow down.

The other horizontal line on the chart is a green line. This represents the level at where the market would be 80% of fair value, or under fair value by 20% or more, a discount. If a company’s stock is generating a good dividend and trading at a discount, it can be an excellent opportunity.

Right now the market, in general, is trading in the fair value range at 1.075 of fair value which translates to 7.5% above fair value. That is well within the fair value range. Based on the fair to improving economic activity we are expecting in 2012, it appears we may be in this range for some time going forward. This is the most likely scenario.

What could realistically change the expectation and move the market into an overvalued or undervalued situation. The market could move into undervalued territory, below the green line, if the Euro is dropped as a major currency without an orderly process. It would not necessarily be the Euro that makes this happen but, the resulting uncertainty about European growth, default on sovereign debt and how significantly this would impact the European banks. On the other hand, the market could potentially move into overvalued territory, above the red line, if an orderly resolution is found for the European debt problem and economic growth accelerates throughout the world. The global economy is much stronger than most people realize and it is moving in a slow but, positive direction as it rebuilds. There are certainly other surprises and unexpected possibilities and right now we believe the most likely situation is a rational move for 2012 in the fairly valued market range holding around the white line.

In the next discussion we will take a look at individual sectors where the fair value analysis can add understanding as to why certain areas appeared to excel while others languished.

If you have questions, write me at Until the next time …