S&P 500: Does A Great First Half Signal More Gains Or Trouble On The Horizon?

Includes: DIA, SPY
by: Informal Economist

Recent headlines have pointed to the past in an effort to predict that the market will continue its upward climb through the end of the year. A number of articles across multiple finance websites touted this year's market rise as being the best first half of a year for the Dow Jones Industrial Average (DIA) and S&P 500 (NYSEARCA:SPY) since 1999. According to some of these articles, history would indicate that when the market begins a year as well as it has this year, it is likely to do well in the second half of the year. Some of these articles also pointed to the recent gains in both indexes as being positive news and referenced rising consumer sentiment and other indicators as positive backing for the market rally to continue. A detailed look at historical market P/E ratios on the S&P 500 along with ensuing returns makes a compelling case for volatility in the coming years. Further, a quick view at some historical and current charts on the Dow points out the reasons investor should tread lightly.

A Comparison of Charts - 1999 and Now

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The chart above shows the growth of the S&P 500 for the first half of the year in 1999. The chart below shows the growth of the S&P 500 for the year-to-date through June 28, 2013. You will notice they do look somewhat similar, hence the many articles pointing out this year as being the best first half for the S&P 500 since 1999.

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Here's the problem with assuming recent growth means continued increases. The chart below is a continuation of the first chart above. This one shows the S&P 500 in the months and years through 2002 following its wonderful 1st half performance in 1999.

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Following its grandiose performance through the first half of 1999, the S&P 500 did in fact continue upward through the second half of the year and proceeded to a high of over 1,500 in September 2000. However, what ensued shortly after was two years of extreme volatility and market declines as the S&P 500 plummeted more than 35% over the next year and a half through September 2001. While a great start to the year in 1999 for the S&P 500 certainly led to a good second half, it certainly didn't mean additional years of market advances. While these charts and this article are not meant to illustrate that we are headed for a repeat of 1999-2001, they are meant to point out the problems many investors face when sorting through the daily comments and news. A great start to a year or recent gains in the market are far from indicators that the markets will continue on an indefinite path upward. What is an indicator of a possible tough road ahead is the current valuation of the S&P 500 as measured by the Shiller P/E ratio.

Current Shiller P/E - 1999 and Now

The current Shiller P/E ratio of the S&P 500 is 23.49. The Shiller P/E in June 1999 was 42.18. The S&P 500 was clearly at a significantly higher valuation in the beginning of 1999 than it is today. Anyone would view the charts above and make the case that they are not relevant because of the discrepancy in valuations between then and now. However, in the late 90s, the market had the technology boom at its back. Many people believed technology would change the business world and the future forever and used that as the reasoning to support a higher market and rich valuations. A common belief was that technology would allow business to do things they could have never accomplished before, spurring them to grow faster and improve earnings. There were reasons for investors to believe the times were different and reason to believe the markets could continue higher even at the inflated levels. There was a true bubble in the stock market. Technology did change the world, but it didn't change the fact that stock prices and the values of companies are ultimately a product of the company's current earnings, future growth potential, and ultimately return to investors.

Current Valuations May Signal Volatility Ahead

An interesting reference point for long term valuations is to compare the Shiller P/E of the S&P 500 today to its historical averages and ensuing returns. Markets will obviously always rise and fall over time with changes in growth expectations, sentiment, political volatility and hundreds of other factors. But the fact remains that markets tend to return to the mean over time. Further, historical P/E ratios, when viewed over rolling time periods, can provide an indicator of expected returns. This is due to the fact that markets will ultimately overcorrect in both directions, leading to an average over time. Because of this, a high P/E ratio would indicate the markets have gone too far to the upside and will inevitably correct to head back toward the mean. Likewise, a low P/E ratio indicates the markets have fallen too low and will rise toward the mean. When viewing the historical Shiller P/E ratios at given points in time, there is a clear correlation between a low P/E and subsequent high returns as well as a high P/E and subsequent low returns.

Beginning Shiller P/E Average 10-Year Forward Return
< 9.6 10.30%
9.6-11.9 10.10%
11.9-13.8 9.10%
13.8-15.7 8.00%
15.7-17.3 5.60%
17.3-18.9 5.30%
18.9-21.1 3.90%
21.1-25.1 0.90%
>25.1 0.50%
Table Developed with Data Sourced from the Robert Shiller, Yale University Online Data

The above table shows the average annual ten year returns following the market reaching certain valuation levels based on the Shiller P/E. An investor buying the S&P 500 index when the Shiller P/E was below 10 would have experienced a ten year average return of 10.3%. The same investor buying the index at a different time when the P/E ratio was above 25 (as in early 1999) would have seen significantly lower returns of .5% over the following ten years.

The current Shiller P/E ratio on the S&P 500 of 23.49 would indicate that returns from this point over the next ten year periods may not be great.

Going Forward

While the value of a company is ultimately a reflection of the company's income, current and future growth potential, ability to return money to investors, and a number of other factors, the stock price is merely a reflection of what one investor is willing to sell it for and another is willing to pay. Because of this, stock prices can swing wildly between extremes on the high and low side; hence the 1999 market levels that were ultimately unsustainable. However, this also means that the markets could go significantly higher from where we are today, regardless of valuation levels. If the majority of investors believe the market will continue upward, they will continue to buy, driving prices higher. Unfortunately, there is no way to know what will happen with the S&P 500 and other indexes through the end of this year, or even over the next few years. This article is simply meant to give another viewpoint in contrast to some recent headlines that have indicated the markets will head higher if history is any indicator. In some ways, history may indicate the S&P 500 is headed higher from here, but in other ways it may indicate we are in for continued volatility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.