Shares RouteMap: Fair Value Line

 Profit from divergences between actual prices and fair value

Sample of our summary chart. The red up + down arrows show the track record of our technical algorithm. The thin yellow and green lines show fair value based on profits and interest rates or bond yields. Forecasts are different colours.

This strategy is intended to show the index level that can be explained by economic factors based on past relationships over very many years. Divergence between actual levels and predicted levels show the extent of over- or under-valuation based on investor euphoria or fear prevalent at any point in time. Fundamental value is derived from the extent of over - or under-valuation of share prices compared to fair value depending on the rate of inflation or bond yields, after cyclically-adjusting profits. (See Cyclically-Adjusted Real PE Ratio and Valuation versus Other Assets)
 
The stock market index is shown as the thick white line on the right hand axis. The two explanatory variables use the left hand axis. Fair Value using inflation is the yellow line. Using bond yield it is the green line. Best Guesses for the next couple of years are show in orange and pink respectively. For comparability, stock market indices have been rebased to set year-end 1994 at 100.
 
These Best Guesses suggest what would happen to Fair Value, based on Consensus Forecasts for inflation, bond yields and our own Top-Down EPS forecasts for company profits. (See Earnings Per Share)
 
As historic data for Earnings per Share is seldom available for entire markets from official sources, this series has been derived from a variety of other sources of historic data. In order to achieve compatibility these have required considerable adjustments. Thus even the historic data should be considered as estimates only.
 
Please note the differences between these Summary charts and those for other RouteMaps. Since income is not a major consideration for investment in shares, stock market indices are shown as price only and not in terms of total return.
 
Where European currencies have been converted into Euros, the legacy data of the individual countries have been used as the basis for historic data and converted into Euros at the fixed exchange rates at the time of unification. Thus, for example, Deutsche Mark bonds are used for Germany and French Franc bonds are used for France up to year-end 1998, but both are now based on a common set of bonds denominated in Euros. EPS continue to be based on companies domiciled in each country.
 
Fair Value based on long-term bond prices performed well as a valuation strategy until 1998. (See also Liquidity Charts). However Fair Value based on inflation has been a reliable valuation strategy throughout the period, and especially so in sophisticated markets. (See Cyclically-Adjusted Real PE Ratio)