Sunday, November 9, 2008

Jeremy Siegel's Mistake

Jeremy Siegel's Mistake: Why Stocks Are NOT "Dirt Cheap"

By Henry Blodget | 7 November 2008

Yesterday, we noted that Wharton professor Jeremy Siegel's "fair value" estimate for the S&P 500 is a startling 1380, which is about 40% higher than most other estimates (Robert Shiller, Jeremy Grantham, Andrew Smithers, John Hussman, et al). Prof Siegel, who is now a pitch man for WisdomTree funds, uses this estimate to conclude that stocks are "dirt cheap." The other experts, meanwhile, who use a consistent, historically predictive, and fully explained methology, estimate that fair value is around 900-1000, about where we are now. In their view, stocks are just fairly valued. [[and would put the lower bound of this market, ie, 20% to 25% below "fair value" at around 700 to 800.: normxxx]]

So who's right?

In our opinion— and the opinion of one of the smartest money people we know (also a PhD)— Shiller, Grantham, Smithers, et al. are right and Siegel is wrong. Our credentialed friend also examined Siegel's analysis and then explained what he believes is Siegel's mistake. Prof Siegel bases his estimate on two variables: 1. "Trended S&P 500 earnings" of $92; and, 2. a PE of 15 ("average" over the last century)

Multiply these together, and you get the 1380 "fair value" estimate. Prof. Siegel's error, it appears, is in using a PE that is too high. The 15X average PE for the S&P 500 is what you get when you use professor Shiller's methodology, which averages 10 years of trailing earnings (and, therefore, if profit margins are statistically 'normal', uses earnings of about 4 years ago). Prof Siegel's earnings estimate, meanwhile, is a forward estimate— one that adds about 5 years of trended growth (6% a year) to the Shiller estimate, but uses the same PE. [[Prof Siegel's calculations has the effect of significantly increasing earnings over those of 4 years ago— which, by the way, is far from what we are currently witnessing as to future earnings trends.: normxxx]]

We suspect that, if Prof Siegel performed the same "trended" analysis over the entire 20th Century, the average PE for forward trended earnings would be about 11X-12X, not 15X. This, we expect, would produce a fair value estimate much closer to that of Shiller, Grantham, Smithers, et al. Shiller's PE analysis is below: [[(And, according to my sources and calculation, the PE ratio is not due to bottom for another two years or so.): normxxx]]

Click Here, or on the image, to see a larger, undistorted image.

See Also: Jeremy Siegel's Strange Claim: "Stocks Are Dirt Cheap"

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