Sideways Stock Market Still Has A Ways To Go

Includes: DIA, QQQ, SPY
by: John M. Mason

What should one expect from the stock market given the re-election of President Obama?

Using the S&P 500 index as a guide, my answer would be that the stock market will continue to cycle around the sideways trend that has been in place since around 2000 for most if not all of his next term. If one tries to smooth the volatility of movements in the stock market by using a relatively long moving average, one observes that the S&P 500 stock index has roughly been constant for the last twelve years.

If one reviews the history of the post-World War II stock market, one can observe that the S&P stock index tends to move in roughly seventeen-year periods. That is, the S&P index grew throughout the 1950 to 1966 period. Then the S&P index remained relatively flat for the 1966 to 1983 period before rising again in the 1983 to 2000 period. If this pattern continues, then the S&P 500 stock index should continue to trend sideways for another three years or so before achieving another period of growth.

Even though there were four recessions in the 1950 to 1966 period, the economy was recovering from the Great Depression and benefited from the return to peacetime following a major war. In the period from 1966 to 1983, the United States economy went through four recessions while in the next seventeen-year period there was only one recession. Since the year 2000 the United States has experienced only two recessions but one of them was the Great Recession that, in modern times, was only surpassed in length and depth by the Great Depression. The period of recovery since the end of the Great Recession has seen only a very modest rate of economic growth and this slow growth is expected to continue for another year or so.

It is interesting that another set of data also seem to mirror these periods of economic growth and stock performance. This is the statistical series called CAPE, which was constructed by the economist Robert Shiller. CAPE stands for Cyclically Adjusted Price Earnings. Shiller constructed this series to remove some of the volatility and special impacts that hit company earnings reports and that tend to result in highly variable Price/Earnings figures.

Over time, in many statistical series, there tends to be a "regression to the mean" in the data. That is, the data will fluctuate around the mean value of the series and will tend to revert back toward that mean value whenever series values move above the mean or below the mean. CAPE tends to "regress to the mean" of the series.

The first estimate for the value of CAPE in October was 21.45. This value is substantially below the mean of the CAPE series so the expectation is that CAPE will have to fall sometime in the future. First, it must be stated that current value of CAPE may diverge from its mean value for an extended period of time. But, over time, the tendency will be for CAPE to return to levels more closely aligned with its mean value. Second, the regression to the mean can either be accomplished by changes in stock prices, changes in earnings, or, a combination of the two.

For example, earlier this year, CAPE was expected to decline because corporate earnings were expected to rise as the economy began to expand at a faster pace. But, earnings have not lived up to expectations, especially in the third quarter, and, as a consequence, this means that the only way for the CAPE ratio to decline is for prices to decrease. And that is what we have seen over the past month or so.

If economic growth continues to remain tepid, earnings performance will also tend to be tepid, and this would imply that stock prices would have to decline further to bring down the CAPE from its current levels. Over the longer term, however, the performance of the CAPE variable tends to perform relatively closely to the trends mentioned above.

For example, the value for CAPE peaked in 2000. It has been trending downwards ever since as the S&P stock index has trended sideways. The CAPE variable rose from 1983 to the peak it reached in 2000, the period when the S&P stock index grew. In the 1966 to 1983 period, the value of CAPE declined as the S&P 500 stock index trended sideways.

If recent history repeats itself, real GDP should grow only modestly over the next few years, corporate earnings should not be too robust over this time, so that the only way for CAPE to "regress to the mean" would be for the S&P stock index to continue to fall. If this were to take place it would exhaust most of President Obama's second term!

Analysts seeking ways to justify a more bullish picture for the next several years attack the CAPE approach. For example, Wharton finance professor Jeremy Siegel argues "the current CAPE for domestic stocks includes a 90 percent annual earnings decline in the first quarter of 2009." As a consequence he continues, "You're averaging in an unbelievable hole in profits."

The arguments against Siegel's point of view is that this is just what the averaging of the earnings data is supposed to do. In the 2000s we did experience two substantial declines in profits, the first coming after the dot-com bust, but we also had a period of extreme monetary easing on the part of the Federal Reserve along with the Bush tax cuts, which led to a sustained period of credit inflation in the economy that produced some pretty inflated levels of profits.

If the excessive declines in profits should be removed from the data, then so should the inflated levels of profits that were also experienced during the decade. But, this is exactly what "averaging" is supposed to do, even if in a modest way.

I expect that stock prices, as represented by the S&P stock index, will remain in a bank of roughly 1100 to 1500 over the next four years or so. For CAPE to decline towards its historical mean given my relatively modest projection for the performance of corporate earnings over the near term consistent with a relatively modest projection for economic growth over the same time period, I expect that stock prices will tend to be around or below the middle of this range.

This is saying that I am really expecting the "new normal" of economic growth to be in the 2.0 to 2.5 percent range for most of President Obama's second term in office. (It could be worse if the European economic situation spills over into the United States, causing the U.S. to decline into another recession.) If this turns out to be the case then the performance of corporate earnings cannot be too robust.

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.

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