The rational price of a stock is the price investors would pay if they were thinking clearly. You can learn all you need to know, and more, in my earlier post that deals with “Rational Value.” So I won’t take the time for that now.

This value is very useful when dealing with good quality companies whose operations have been consistently healthy and whose value has grown predictably. With it, you can tell when the stock of that company is selling at, above, or below a reasonable price. Needless to say, the ability to place a specific and absolute value on a share of stock makes the whole process of long-term investing less of a gamble and more of a business—which is precisely what it ought to be.

Today, for example, let’s take Factset Research (FDS). The price of Factset at the close, today, was $54.92. With a HVR or 74.7, the rational price for Factset is (54.92 ÷ .747) = $73.52. That means that, when the herd has come to its senses, it will recognize that as its proven value.

My point is that you cannot apply the same logic to the S&P500, let’s say. Because the index consists of not only companies that are worthy of consideration for investment. It consists of a whole lot that are not. The index is not predictable and therefore it is not at all rational. Most who write about investing use historical market movement to prove their points and offer it up as empirical evidence that some theory works—or more often, doesn’t.

The median PE of the S&P500 over the past 10 years has been 25.46. At the close today, the PE of that index was 143.17. (The PE is so high because so many people continue to pay high prices for stocks whose companies are not earning what they did. So it’s irrational.)

If we try to calculate the rational value of the S&P500 based upon these numbers, the S&P500 would be at 174.8, when the herd comes to its senses. Not only is that not a very good prospect, it would seem like one good reason not to buy the index. Any comments?

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