Vanguard Large Cap Index Fund

The Vanguard 500 Index Fund (Symbol: VFINX) and the Vanguard Total Stock Market Index Fund (Symbol: VTSMX) are most widely held index funds with $103 Billion and $56.6 Billion in assets respectively. The 500 Index Fund tries to replicate the S&P 500 Index and Total Stock Market Index Fund uses MSCI US Broad Market Index. The Total Stock Market Index used to replicate the Dow Jones Wilshire 5000 Composite Index until recently, but Vanguard chose to switch the fund to follow MSCI index; which is in their words a better index because, the new index takes into consideration the “float” of a stock before assigning the weight in the index. In Vanguard’s view, “a weighing based on the amount of total shares outstanding, all of which may not be available in the market, does not necessarily provide a true representation of the publicly available US market”.

Another Vanguard offering in the index arena has gone relatively unnoticed by many. I hardly hear anything mentioned in the financial news media about this new index fund. The Vanguard Large-Cap Index Fund (Symbol: VLACX) is the new index fund in town. It does not hold 500 stocks like the 500 fund or more than 3500 stocks like Total Stock Market fund. It holds “a broadly diversified index of stocks of predominantly large US companies” in MSCI US Prime Market 750 Index (Bloomberg Ticker: MZUSP). Even though this fund is more than 1 year old, the assets under management were only $188 Million as of 3/31/2005.

It is just about time this stock fund takes off and competes with the other two Vanguard offerings in the Large Cap Blend arena for incoming assets. As usual, Vanguard requires $3,000 minimum for the regular accounts and $1,000 for IRAs. The expense ratio was 0.20% as of 12/31/2004.

REIT Index Overvalued?

It always helps to avoid long positions in any extremely overvalued sectors of the market. From time to time, every investor should compare the relative valuations of various market indexes to identify the overvalued sectors.

I was going through the P/E ratios of all Vanguard stock index funds to find out which index fund is currently fielding the highest P/E ratio. I looked at every blend, Growth and Value indexes but nothing significant jumped out. In other words, I did not find anything unexpected.

Until.

Until, I looked at the P/E ratio of the Vanguard REIT Index Fund (Symbol: VGSIX). The P/E ratio of VGSIX is 38 as of 3/31/2005. No, that is not a typo. It is 38. Thirty Eight.

The Vanguard REIT Index Fund tries to mimic the Morgan Stanley REIT Index. This indicates that the REITs are extremely overvalued. Also, -5.3% earnings growth makes the matter even worse.

Money Market Fund Yield

The yield of the Vanguard Prime Money Market Fund (Symbol: VMMXX) is now at 2.51%. The Vanguard Federal Money Market Fund (Symbol: VMFXX) is also approaching 2.50% mark. It currently stands at 1 basis point short at 2.49%. The Federal Reserve is expected to raise the rate at the next meeting, so these rates should approach 3% in the next few months.

I hope Vanguard comes up with a new “Low Duration” or “Ultra Short Bond” type of fund to fill the gap between the Money Market Funds and Short Term Bond Funds. Almost all other major fund complexes provide such a fund. The duration of this type of fund should be between 6 months and 1 year.

Equity Duration Of The S&P 500 Index

The duration of bond measures the price sensitivity of the bond to the interest rates. Let’s suppose that the duration of a bond is 2 years. If the interest rate falls by 1% then the price of the bond will rise by 2%. If the interest rate goes up by 1% then the price of the bond will fall by 2%.

What if we had a similar measure for stocks? What if we can come up with the equity duration, which will tell us the interest rate sensitivity of the stock to the rising or falling interest rate.

The Standard and Poor’s (S&P) has done just that. They have “developed a simple model of equity duration that uses the dividend discount model and incorporates the sensitivity of growth” to interest rates. Duration is judged higher for high growth stocks. The S&P does recognize that the “duration estimation is an evolving science”. They intend to publish this data every year to provide the perspective on the equity valuations.

So, What is the duration of S&P 500 index? This is what the S&P estimates: “We estimate the duration of the S&P 500 index to be 19 years at the end of third quarter of 2004. It has risen from its level of 15 years at the middle of 2003, suggesting that the market has become more rate-sensitive. However, duration of the index is still below the 22-23 years figure seen in 1999”.

Legg Mason Value Trust

Legg Mason Value Trust (Symbol: LMVTX) is the only fund to have beaten the S&P 500 index for the past 14 consecutive calendar years. Not only that, the average annual return for the last 10 years stood at 18.58% as of 12/31/2004. Comparing that to the 12.07% return of S&P 500 index for the same time period gives an idea that Legg Mason Value Trust hasn’t been barely beating the S&P 500 index. But, it has been beating the index by more than 6% on average.

After tax returns are also phenomenal. For period ending 12/31/2003, the 10-year return after taxes on distributions and sale of fund shares was 15.24% for the Value Trust. Comparing this to the 11.07% after tax return for S&P 500 tells me that the Value Trust has not been beating the index, but it has been actually hammering the index.

After such success one would expect that there would be tremendous asset growth in this fund, but that is not the case here. The fund assets are manageable at around 12 billion dollars. This is not the Dodge & Cox Stock fund situation, where assets are now approaching 40 billion dollars.

Only one thing though, expense ratio of Value Trust stands at around 1.72% according to the prospectus, which is above average for this size fund.

Buying Stock = Owning Future Earnings

What is the reason for buying a business?
Why would someone pay hard-earned dollars for a share of a company?

When you buy a stock, you lay a claim on the future earnings on that stock. You effectively “own” the future earnings of the company. Let’s consider the broad market index today. The S&P 500 companies are expected to earn $70.20 this year. The S&P 500 index closed at 1181.21 today. If someone buys a share of S&P 500 at $1181.21 today, this person is expected to earn $70.20 dollars in 2005 on the $1181.21 investment.

It is widely known that earnings growth for the S&P 500 in last 70-75 years has been around 5%. If earnings grow by 5% in 2006 from 2005 levels, then this S&P 500 stockholder will earn $73.71 in 2006 from the investment. Let’s continue this further: 2007 earnings should be $77.40, 2008 earnings should be $81.27,…………..

The table below lays out the estimated earnings for the next 20 years. Our S&P 500 stockholder owns these earnings as long as she does not sell her stock.

Calendar Year	S&P 500 Expected Annual Earnings	Estimated Fair Market Value
2005	$70.20	1053.00
2006	$73.21	1105.65
2007	$77.40	1160.93
2008	$81.27	1218.98
2009	$85.33	1279.93
2010	$89.59	1343.92
2011	$94.07	1411.12
2012	$98.78	1481.68
2013	$103.72	1555.76
2014	$108.90	1633.55
2015	$114.35	1715.23
2016	$120.07	1800.99
2017	$126.07	1891.04
2018	$132.37	1985.59
2019	$138.99	2084.87
2020	$145.94	2189.11
2021	$153.24	2298.57
2022	$160.90	2413.50
2023	$168.94	2534.17
2024	$177.39	2660.88
Total	$2321.23	-

In the 20th year of her investment (in 2024), she should earn $177.39. As the final total in the above table indicates, her total earnings from her owning this stock for 20 years should be $2321.23.

Let’s suppose at that time, in 2024, our investor decides to sell her stock of S&P 500. Assuming the normal valuations at that time, she should be able to sell her one stock for 15 times the earnings. That is, if S&P 500 stock is expected to earn $177.39 in 2024 then it should sell for $2660.88 ($177.39*15 = $2660.88).

What is the total reward by owning the S&P 500 stock for 20 years?
Total Reward = Total Earnings + (Final Price – Initial Price)
= $2321.23 + ($2660.88 – $1181.21)
= $3800.90

We did not re-invest the earnings in this calculation. If the earnings are re-invested in the stock, then the “Total Reward” should be much higher than $3800.90.

2005 Earnings Estimate for S&P 500 Index

The Standard & Poor's (S&P) web-site lists the earning estimates for the S&P 500 index in a excel spreadsheet. The 2005 estimates for each quarter are listed in the table below. The estimates are for operating earnings and as reported earnings.

Quarter Ending	Operating Earnings Estimate	Reported Earnings Estimate
03/31/2005	$17.34	$17.70
06/30/2005	$18.51	$17.80
09/30/2005	$19.15	$18.10
12/31/2005	$20.01	$16.60
2005 Totals	$75.01	$70.20

The operating earnings for the calendar year 2005 are estimated at $75.01 at this writing. The historical average P/E for S&P 500 is about 15. The "fair value" of the S&P 500 index at the end of 2005 should be around 1125.15 (75.01 * 15 = 1125.15) with this valuation criteria. Today, the S&P 500 index stands at 1184.07. Assuming from now to end of this year the index goes nowhere, the index is about 5% overvalued. Mind you, this is based on operating earnings, which does not provide the true glimpse of the profit picture.

As Reported Earning estimate stand at $70.20 for 2005. This indicates the "fair value" at the end of 2005 at 1053(70.20 * 15 = 1053), which would make the index about 12% overvalued.

The Standard and Poor’s does not provide the “Core Earnings” estimates at this time. The common wisdom is that the core earnings will come below the operating and reported numbers, and thus would make even stronger argument of index being overvalued as of today.

Anyway you look at it, the S&P 500 index looks at least 5% to as much as 15% overvalued.