The economy and stock market are in constant motion. Whether evolving in an expansive or contractive manner, dynamism occurs. Therefore, pinpointing a fair value for the stock market is incredibly difficult and time consuming. My approach is to use an approximation.
I rely on the P/E ratio for the S&P 500. Price data is readily available, and forward earnings data can be predicted with a reasonable degree of accuracy. Now, some may argue that predicting forward earnings is an imperfect measure. Purists may further argue that forward earnings ignore future cash flows to equity holders. To these arguments, I agree. However, gauging the price and forward earnings of the S&P 500 provides relative context about implied returns. Though imperfect, it enables recognition when the market is venturing away from the bell curve. It is at these movements where I will engage in market timing in an attempt to generate alpha. As the market moves away from (what I deem as) a reasonable range, I will rotate in or out of positions. This allows for buying stocks when the market is undervalued and selling stocks when the market is overvalued. It also allows me to exit weaker positions on market strength and purchase stronger positions on market weakness. This is a simple concept, but one that requires a level head, a strong stomach, and a cash cushion.
For the next four quarters (3Q09-2Q10), I estimate that the S&P 500 will earn $65-75. I am willing to pay 12 times earnings, which is an implied return of 8.3%. The 12x earnings ($70) puts my fair value at approximately 840 (see chart below). In 2009 (through the end of July), the market has progressed from undervalued to fairly valued to overvalued. The March low of 666 implied earnings of $60 and implied return of about 9% (P/E of 11). This was a buying opportunity (that I participated in). In April, only a month later, the market had rebounded to what I consider fairly valued (840). By the end of July, the S&P 500 reached 987; this implies earnings of $70 and a P/E multiple of 14 (about 7% return). This is increasingly becoming a selling opportunity (something I again am participating in).
As a side note, I recently read that the S&P 500 book value is about $500. At 987, the market is selling at about two times book value. Given the increasing risks to the economy (see Investment Philosophy page), paying 2.0 book seems high.