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I recently had the privilege of interviewing (via e-mail) financial economist Andrew Smithers, who consults on international asset allocation to some of the world’s largest fund managers. Smithers is the co-author of Valuing Wall Street (2000), which I highly recommend. In my opinion, he's one of the few strategists out there actually worth listening to.

I asked him what his estimate of fair value for the S&P 500 is. He responded:

"On the latest data available it seems to be fairly valued at 770.

US Stock Market Value as at 31st December, 2008 (S&P 500 = 903)

Valuation Method Over (+) or under (-) valued

CAPE 4.10%
Tobin's q including statistical discrepancies -8.50%
Tobin's q excluding statistical discrepancies 30.60%

The above table comes from a recent report. The cyclically adjusted PE covers the whole market but q is limited to non-financials. I prefer the q calculation which excludes the statistical discrepancies, as the other produces values which are inconsistent over time and reflect the distortions from “mark to market” accounting. At 770 the average of CAPE and q (ex statistical discontinuities) indicates fair value."

[Smithers expanded on this answer today:

“On the latest available data the S&P 500 seems to be fairly valued, or even a little under valued, using either q or the cyclically adjusted PE. For example the market is selling at 12.7 times the average of the past 10 years earnings per share (at current prices), which is nearly 20% below its long term average.”]

He also had some very interesting things to say on (among other topics) the exceptionally high price of liquidity and why the conventional wisdom that Japan is cheap may be incorrect. The full transcript is available at:
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