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Weekly eLetter 4/18/2019 – Mulling the Report(s)

As promised, here is our fully un-redacted eLetter for this week.

While the main topic of conversation in many quarters is the release of the long-awaited Mueller Report and its potential repercussions, we think it is wise to keep in mind that the report is just one ingredient in the minestrone of financial markets, and even then the report may end up being something of a national Rorschach test with readers seeing what they want to see. Fortunately, we have a few other reports to digest and, of these, there is more good news than bad.

Speaking of good news, it seems that we can get too much of it. When the markets approach new (or even old) highs it is tempting to start thinking that they should then turn down — just to keep things fair. Of course, that’s not reasonable. It’s like thinking that if a flipped coin has come up heads 6 times in a row, the odds of tails on the next flip have increased. We know that isn’t true, that the odds on every flip are still 50/50, but it doesn’t seem ‘fair’. Fortunately, while there is always risk in the markets, there is also a lot of information that can be used to take our decisions far away from simple chance.

Regular readers of this newsletter know that two of our favorite economists are Brian Wesbury and Robert Stein, both of First Trust Advisors. They considered the phenomena I just described above and offered this:

“Through Friday’s close, the Dow is up 13.2% year-to-date, while the S&P 500 is up 16.0%. To reach our year-end targets, the Dow would have to gain another 8.9% while the S&P 500 would have to rise 6.6%.

We think investors should be undeterred by new record highs. To assess market valuations, we use a capitalized profits model, which takes the government’s measure of profits from the GDP reports and divides by interest rates. Think of it this way: if profits are higher, stocks should be higher, too; if interest rates are higher, stocks should be lower, as they compete against an alternative with a higher rate of return.

Our traditional measure – using a current 10-year Treasury yield of about 2.57% – suggests the S&P 500 is still massively undervalued. At the end of last year, we used 3.40% for the 10-year yield, and generated a fair value on the S&P 500 of 3,100. Now that looks like an aggressive call for long-term yields. Using, say, 3.00% for the 10-year puts fair value at 3,500. The model needs a 10-year yield of nearly 3.6% to conclude the S&P 500 is already at fair value, with recent profits.”

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