S&P 500 – what to expect?

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The surge in global stock markets led me to have a look at the valuation of the equities and especially the S&P 500 Index. In the paragraphs below I consider various valuation measures in order to get a feel for whether the Index is overpriced or not.

Robert Shiller’s cyclically adjusted price earnings ratio (CAPE)
The CAPE ratio, defined as the ratio of the inflation-adjusted S&P 500 Index to the average of the past ten-year inflation-adjusted trailing S&P 500 annual earnings, is currently at 21.39. That compares to the historical average of 16.4 since 1881 and is at the top end of the range pre-2000. Barring the first quarter of last year when the ratio fell below 15, it is at the lower end of the range over the past ten years. So yes, the S&P 500 is expensive on a long-term basis but inexpensive compared to the past ten years.

Future returns
John Hussman, President of Hussman Funds, recently predicted that investors are likely to achieve poor returns over the coming five- to seven-year period – similar to those over the past decade. He estimated total annual return for the next seven years to be -0.07% given the 2% dividend yield on the S&P 500 when he went to press. His calculations are based on the long-term growth rate of S&P 500 dividends over 70 years of 6% and a median dividend yield of 3.7% since the post-war period.

Hussman probably concentrates on returns over seven-year periods as, according to the NBER, the average full business cycle from 1945 to 2001 was 67 months, while the most recent business cycle lasted 81 months.

I have calculated the estimated seven-year returns by applying Hussman’s formula based on the 6% annual growth in dividends and the average dividend yield of 3.7% and 2.1% over 70 years and ten years respectively.

It is shown how inexpensive the market was in the 1980s, providing estimated growth in excess of 10% per year. The increasing expensiveness in the period leading up to the bubble in 2000 is remarkable as the estimated return dropped to zero and below.

Sources: I-Net Bridge; Plexus Asset Management.

It is also evident how inexpensive the S&P 500 became in the first quarter of last year. Even with the higher average dividend yield over the past 70 years the estimated returns over the next seven years approached 10% per annum.

You may ask how the actual seven-year return panned out. The actual return (red line) on the graph below is the capital return per annum over the next seven years that you would have achieved if you had invested in the S&P 500. It is shown that in the 1980s the market concentrated on the average dividend yield over the past 70 years but has re-rated since then.

Sources: I-Net Bridge; Plexus Asset Management.

From the above I agree with Hussman that if the average dividend yield over the past 70 years is the benchmark over the next seven years, the estimated annual return over the period would be -0.8% given the current dividend yield of 1.9% on the S&P 500. I view the 70-year dividend yield benchmark as very conservative, though I also view the ten-year dividend yield benchmark as optimistic. I am of the opinion that the average yield is likely to be something in between as quantitative easing is likely to be inflationary.

CAPE ratio and future growth combined
In the graphs below I have combined the CAPE ratio with the future returns based on average dividend yields over ten and 70 years respectively. I believe these charts are extremely important tools to determine the valuation levels of the S&P 500.

Sources: I-Net Bridge; Plexus Asset Management.

Sources: I-Net Bridge; Plexus Asset Management.

Trailing price earnings ratio
On a trailing PE ratio basis the S&P 500 is at the lower end of the range since 1993 but in the upper range since 1881.

Price-to-book ratio
The price-to-book ratio of the S&P 500 is 2.3 times and is inexpensive compared to the historical average of 2.9 times since 1981.

Source: Various internet sources.

Tobin’s Q ratio
The Tobin’s Q ratio is calculated as the valuation of the whole market in relation to the aggregate corporate assets. It displays valuation patterns similar to those of the price-to-book ratio. According to dshort.com, the ratio is estimated to be approximately 1.0. It is at the upper end of the range since 1900 but at the lower end of the range since 2000.

Source: dshort.com.

In conclusion, the S&P 500 is in my view neither extremely cheap nor very expensive. The dominant factor is how dividend yields will pan out over the next seven years. If the average of the past ten years holds, the market is likely to return in excess of 6% and is therefore relatively inexpensive. However, the average dividend yield will rise if significantly higher inflation is on the cards, resulting in negligible returns over the next seven years. What is clear, though, is that investors should scale down their return expectations as the likely outcome is somewhere in between.

Good old-fashioned stock picking remains my favored approach to equity investment in developed markets. (I will devote a separate post to emerging markets over the next few days.)

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1 comment to S&P 500 – what to expect?

  • Thanks for this great summary and analysis. One point to add regarding the q-ratio. In their work on q-ratio (Valuing Wall Street), Smithers and Wright showed why q-ratio averages around .7 and why P/E ratios are q-equivalent.

    By that measure, the equity markets are 30-35% overvalued at this point, and that’s assuming it doesn’t overshoot on the downside. It is also roughly the same valuation level as we saw around the pre-1970’s bear market.

    Separately, based on work done by multiple academics and popularized by Ed Easterling, a move away from price stability (towards deflation OR inflation – doesn’t matter which) will probably lead to margin compression. Easterling called this the y-curve. That should lend itself to poor contribution to returns from margin expansion going forward.

    Just some thoughts that I hope will add to the conversation as we muddle through the proverbial “interesting times”.

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