We See a 16% Return in the S&P 500's Future

Let's cut right to the chase: Our research suggests that  SPDRs Trust (SPY), an ETF that tracks the S&P 500 Index, will return 16% annualized over the next three years.

Lest you wonder which hat we pulled that number out of, rest assured that there were no wands or seers involved. And because top-down macro forecasting isn't our bag (what�you were expecting the second coming of Bill Gross?), we kept the focus squarely on the stocks in front of us.

As it turns out, that's a lot of stocks--we cover 2,000 companies, including more than 450 of the S&P 500's constituent holdings. Therefore, we can harness the work that our analysts do in evaluating company fundamentals, such as the presence and durability of competitive advantages each business might boast. That work culminates in a fair value estimate that our analysts place on each stock they cover. We can roll up the fair value estimates that our analysts have placed on the S&P 500's holdings and, voil�!, come up with a fair value estimate for the index as a whole (roughly 1,600 as of Jan. 31).

But how does that get us to an expected return? We ordinarily expect a stock's price to converge to fair value over a three-year time horizon. Assuming that we compound our fair value estimate at the cost of equity--which is the minimum compensation that we demand for owning a stock--the expected return represents the return that will cause the stock's price to converge to fair value at some point in the future, not to exceed three years. This same math holds for an index like the S&P 500, provided we have adequate coverage of its underlying assets (the 450 S&P 500 stocks that we cover account for 99.5% of the index's assets).

Consider then that the S&P 500 was trading at a 15% discount to our fair value estimate as of Feb. 1 and that our weighted-average cost of equity for the index stands at roughly 10%. When you take the two together, it translates to a 15.89% expected return for the S&P 500. Subtract the SPDR's infinitesimal 0.09% expense ratio from that tally, and you end up with a 15.8% return.

Of course, a cushy return does not a screaming buy make. Otherwise, we'd throw caution to the wind and buy nothing but very risky stocks such as biotechs. That's why we have to consider SPDR's return in relation to its risk.

The verdict? We'd recommend the fund at these levels, as investors stand to reap a hefty 5.7% excess return (the difference between SPDR's 15.8% expected return and its 10.1% cost of equity). Put differently, investors can buy a security that's less than half as volatile as our typical below-average-risk stock at 85 cents on the dollar. We'd take that trade.