Stock Market Looks Undervalued by 30%

Yesterday I ran across a graph at yardeni.com (good collection of data here) showing the historical valuation of the overall stock market for the period 1979-2005. The data compare the actual S&P 500 index with "fair value" defined as "12-month forward consensus expected earnings divided by 10-year US Treasury bond yield."

To summarize the data:

1979: Market was undervalued compared to fair value by about 30%;
1980: Market quickly caught up with fair value;
1981-1998: Market tended to track fair value within 10%;
1999-2000: Market rose while fair value fell, producing 30% overvaluation during the dot-com craze;
2001: Market fell, bringing it back in line with fair value;
2002: Fair value rose while market contiinued to slide, producing undervaluation of market by 30%;
2003-2004: Both market and fair value rose, maintaining 20% to 30% undervaluation.

By this simple measure of fair value, today the stock market is 30% undervalued compared to where it historically has traded.

Possible future scenarios are:

1. Analysts' estimated earnings will be revised downwards, bringing fair value down to market;
2. Interest rates will rise, pushing fair value down to market;
3. Market will rise to fair value line;
4. The market vs. fair value gap will continue.

Based on history and "mean reversion" thinking, #4 is unlikely, particularly in the long run. At this point in market history, I think it is a good educated bet that the stock market will converge to (and possibly shoot past) fair value over the next year or two. Unless interest rates rise dramatically (budget deficit and trade balance worries?) or estimated earnings get revised downward quickly (recessionary impact of rising oil prices?), the market should have a lot of room to rise. I am on board in anticipation of a healthy run upwards to fill the 30% undervaluation gap.

From an asset allocation point of view, I think it likely that the generous flow of money that has gone into chasing real estate over the past five years could slow, with some of the money finding its way back into the stock market. The recent revival of venture capital money (2003-2004) following the dot-com bust (2001-2002) is a sign that investor interest in equities is once again on the rise.