The discipline which holds that stocks and the market in aggregate have a fair value based on past, current, and estimates of future earnings. This method is calculated through exhaustive mathematical analysis and statistical back-testing. Through this methodology, a current fair value can be derived. The Iron Law of Valuation is that, while actual prices will fluxuate, the inevitable pull of fair value will win over the long run. This analysis compares the current price to what is historically normal and can further demonstrate the degree of the difference; whether this market is under or overvalued.
Furthermore, by assuming, what has been true will continue to be true and comparing the current price to an expected future fair value, the probability of an expected future average annual return can be derived. Therefore, history gives a fair value: an average, a mean, a best fit. In addition, because stocks are no more than the present value of future earnings, these earnings can be anticipated, then assigned a current value discounted at some function of the Federal Reserve’s ‘neutral policy’ interest rate. It becomes a simple matter to determine whether the current price of the stock market is above or below fair value; whether it is under or overpriced.
Right now, the current price of the stock market is higher than this discipline would expect. But reality often turns theories about the appropriate value of the stock market into junk. Recent history is full of instances where the stock market continued to make substantial gains long after these theories stated otherwise. No one better documents this divergence than Laszlo Birinyi, and he is still bullish.
However, I believe knowing fair value is very important. The Iron Law of Valuation is like gravity. Over the long term, it wins.