Arthur Cloff is an equity portfolio manager working for E-Tuff Investments (E-Tuff) - an asset management firm based in California, USA. Cloff was recently invited to a seminar by the California Investment Council (CIC) in collaboration with the Financial Institute of Portfolio Managers (FIPM). The seminar gathered equity analysts and portfolio managers from some of the leading asset management firms in the USA. Tom Mahard was the guest speaker at the event. After the seminar, Mahard held an informal discussion with Cloff and a few other portfolio managers on the current attractiveness of equity markets in different countries. He made the following comment:

“I have been assessing the equity markets in Europe, with a particular interest in Germany - using the Fed Model. I have gathered the following information about the major stock indexes in the continent:

1). The Euro-stock index forward P/E based on next year’s earnings estimates is 20.67. The yield on a similarly dated 10-year Euro Government bond is 5.64%.

2). The forward P/E for the German stock index based on next year’s earnings estimates is 15.22. Ten-year German Government bonds offer a yield of 7.85%.”

After listening to Mahard, Cloff decided to make an assessment of the U.S. equity market. Exhibit 1 displays some of the information he gathered for his analysis.

Exhibit 1. U.S. Equity Market Information

Moody’s A-rated corporate bond yields	6.7%
10-year T-bond yields	5.5%
5-year earnings growth rate forecast for the S&P 500 Index	11.5%
2-year earnings growth rate forecast for the S&P 500 Index	15.0%
Weight the market gives to 5-year earnings projections	0.10
Weight the market gives to 2-year earnings projections	0.065

Cloff then talked to Mahard about his evaluation of the U.S. market. At some point in their conversation, Mahard made the following comment regarding the Fed model:

“One of the drawbacks of the Fed Model is that the relationship between interest rates and earnings yields is not a linear one. This is a drawback most noticeable at low-interest rates.

However, by incorporating interest rates, the model adequately reflects the effects of inflation on the fair-value of the market.”

Cloff is evaluating T-Wires Enterprises (T-Wires), a small firm in the U.S. The company has experienced high growth and shifts in the use of financial leverage in the recent past. One of the reasons for its success is its ability to completely pass cost increases on to customers. Cloff is using the firm’s own historical P/E for valuation purposes. In his report, Cloff stated that the justified P/E for the firm would be inversely related to the inflation rate, and the higher the inflation, the greater effect there would be on the P/E multiple.

Although Cloff mostly uses the P/E ratio for comparisons between stocks, he also knows that the P/BV ratio can help in identifying excess return opportunities. Recently, when reviewing Masonry Corporation (MC), Cloff found out that the P/B ratio of the company increased considerably, whereas its P/E ratio narrowed by 23%. What’s more, the company’s stock price remained relatively constant over the same time period. Cloff wasn’t sure of the reason behind this scenario.

Question: 

Using the information provided in Exhibit 1, please calculate the justified P/E for the S&P 500 Index (based on the Yardeni Model).