The S&P 500 (SPY) ended last week at a new all-time nominal closing high of 1759.77. How far is the index from its "real" high, adjusting for the effects of inflation? To answer this question, we look at the online dataset provided by Yale economist Robert J. Shiller. The data runs from 1871 to current, adjusting the benchmark equity gauge for changes in the Consumer Price Index. This methodology will give us the purchasing power of the stock market bellwether historically. Below is a graph of the nominal S&P 500 Index versus an inflation adjusted version for the trailing twenty years:
Source: Standard and Poor's, Robert Shiller
For a given date in the past, the real S&P 500 index value is calculated as S&P 500 Index Level at the past date * (CPI Today/CPI Past Date) in order to equate the purchasing power of the index at dates in the past into today's dollars. As one can see above, the all-time real index high was in August 2000. Although the S&P 500 closed at a new nominal high on Friday, the purchasing power of a dollar invested in the S&P 500 is still 12.7% below the August 2000 level.
This invites the follow-up question of whether the S&P 500 can reach its "real" high again in this economic cycle. One thing is for certain, a new "real" high will not be reached because of multiple expansion equivalent to what we saw at its past peak in August 2000. At the end of the third quarter of 2000, the S&P 500 was trading at roughly 26.3x trailing twelve month earnings versus today's P/E ratio of 1.67x. In both nominal and real terms, the constituents of the S&P 500 are producing meaningfully higher levels of earnings today.
There are of course a myriad of different ways to value a market. While using the price multiple to trailing twelve month earnings is a common approach, Shiller, the recent Nobel prize winner, favors looking at cyclically adjusted price/earnings ratios that use trailing ten years of earnings. While some market pundits argue that the market is overvalued given the current Shiller P/E of 24.6 is above the long-run mean of 16.5, it is nowhere near the stratospheric 42.9 in August 2000 near the peak of the tech bubble.
Source: Robert J. Shiller; Standard and Poor's (updated for current nominal index level)
I think that it is pretty clear that the relative valuation of the market today versus its real peak in August 2000 is more justifiable, but that does not answer whether the market will advance to a new high in this cycle and how long it might take. Below is a chart of inflation-adjusted market peaks where each point in the time series graphs the all-time maximum reached to that point in history.
As one can see above, twenty-plus year stretches without new "real" market peaks are not uncommon. The record streak without a new high is, of course, the twenty-nine year period following the 1929 stock market crash that presaged the Great Depression. Our current streak of over thirteen years is not even half as long. Given the rapidity of the market advance from 1991 to 2000, we could potentially see a historically long period without a new inflation adjusted market peak, especially given the outsized valuation of the market in August 2000.
Will me make a new inflation-adjusting peak in the S&P 500 this economic cycle? I expect forward returns to be roughly the earnings yield of the index plus earnings growth given with only modest multiple expansion from the current level. This suggests annual returns in the high single digits or low double digits. With CPI running at roughly 1.5%, we would need an additional eighteen months of gains at my anticipated average return. While I think the market will produce high single digit to low double digit returns on average, there is a necessary wide distribution around that average return. With the S&P 500 260% higher than its crisis-era low of 676.53 on March 9th, 2009, and the credit cycle feeling mature, reaching a new inflation adjusted high appears far from a certainty.
Certainly positive catalysts remain that could take us to a new peak. Dollars sidelined during the economic recession continue to return to the market. Corporate balance sheets are in excellent shape, which could prompt elevated returns to shareholders that boost the market. Shareholder-friendly M&A driven by still low borrowing costs could add another push to the market rally. Questions around economic growth in the remainder of the developed world, notably the multi-year rebuilding and integration efforts in Europe, the spillover effects of slower growth and a rebalancing economy in China, headwinds from needed fiscal austerity in the United States to balance structural budget deficits, risk of a fiscal policy error from the intermittent debt ceiling standoffs, uncertainty around the ultimate unwind of the Federal Reserve balance sheet and the impact on global capital flows, and ever lurking geopolitical risk are all counterbalancing headwinds.
Without a new inflation-adjusted high in this business cycle, we could not see a new real peak until the tail end of the next business cycle, potentially ten years in the future. This type of forecasting is of course fraught with uncertainty with the most notable wild card being the potential inflationary impact of the extraordinary monetary accommodation, which would lower the "real" value of the index. Hypothetically, looking back at the markets ten years forward, one would not be unnecessarily surprised if a twenty-three year period marked by the Tech Bubble, the Great Recession, the European Sovereign Debt Crisis, and the reversal of fiscal stimulus from persistent budget deficits and unwind of extraordinary monetary accommodation had failed to produce a new "real" high. With returns in 2013 (23.4%) approaching the 25.9% post-crisis return in 2009, we have taken quite a leap forward towards a new real index high without uncomfortably stretching valuations, but whether we reach a new "real" peak still feels like a bit of a reach.
As always, I welcome feedback from readers about their own thoughts on when a new inflation adjusted market peak could be reached.