A 120-Year History Suggests The S&P 500 Could Drop To 1630 By Year-End 2020

by: Dennis Dugan
Summary

6 times in the last 120 years, the S&P 500 has reached over-valuation levels near or above 2 standard deviations.

The last time was around late October 2018.

In the 5 times before 2018, the index fell from that +/- 2 standard deviation high, to a level close to, or below, its historical mean (average), now at 1420.

The remarkable thing is it fell all that way in only about 2 years time.

The investment thesis here is clear and simple:  A close to 2 standard deviation over-valuation is a clear danger warning to watch out below.

As I write this, late-morning on 1/4/19, the Dow is up 600 points after being down 660 points yesterday.

Doug Short and Jill Mislinski at dshort.com publish dozens of useful and meaningful charts and graphs each month about the economy and markets. I used a graph of theirs to publish an SA article a few days ago suggesting the S&P 500 could drop to 1760 by the mid-2020's here.

Jill published another monthly article here on 1/2/2019, titled "Regression to Trend: Another Look at Long-Term Market Performance." That article contains some fascinating and valuable information, to wit:

About the only certainty in the stock market is that, over the long haul, over-performance turns into under-performance and vice versa.

Find Jill's article here.

In the article was this graph:

Stanrdard Deviations

I suggest you read Jill's article for some perspective, which I won't repeat here. Plus, it contains another interesting graph illustrating a severe current over-valuation.

My wife and I thought ourselves buy-and-hold investors until 2017 when 3 things happened:

  1. Stocks had become overvalued by close to 2 standard deviations.
  2. T-Bill interest rates started approaching 2%.
  3. Because of capital gains, the average dividend yield needed to fund our great retirement had gone down to less than 2%. At 2.5% from our current T-bills, we now get 25% more in interest income than we used to get in dividends.

I explain why we got out of the market in our "Retirement investing Plan," which can be found here. Suffice to say, when we got out, we were guided by the old saying "when you've won the game, stop playing." Plus, we thought the best way to create wealth in what is expected to be a long-term period of low returns is to miss the "big move down" as the market mean-reverted, and then buy back in at a lower valuation, in what would then be a much lower risk situation but offering greater rewards.

Our general guide is that "reversions to the mean" are one of the most powerful forces in investing. Our specific guide is that we start thinking about getting out of the market when valuations approach 1.5 standard deviations above mean on the way up, and start thinking of getting back in as the market falls through 0.5 standard deviations above the mean on the way down. We don't pull the triggers at those points, but begin preparing for actions by, for example, tightening stop-loss orders on the way up.

We accept the fact the we will miss some gains at the top and will probably incur some losses near the bottom. But 2 things guide our thoughts in that respect:

  1. Bernard M. Baruch's wise saying: "I'll give you the bottom 10% and the top 10% of any (market) move, if I get to keep the middle 80%.”
  2. Buy and holders, by definition, experience those big moves down during mean-reversions, and we don't want to do that because we think missing the big moves down is the real way to create wealth, in the sense of “Bull markets make you money, but bear markets make you rich.” By way of example, in December 2018 the market went below the level at which we sold in 2017 (it's now back above) and all the while we were earning interest income at or above the rate of the yields we were getting while fully invested.

Anyway, we're happy with our decisions but clearly understand they entailed an opportunity-cost risk, and that our path is ours and might not be right for others. We also honor the strategies of true buy and holders. It's just not for us.

OK. So, having gotten out of the market, a lot of our attention is now spent thinking about when, and what triggers would move us, to get back in. Of course, the primary consideration would be after the big move down. But that needs some definition.

In a recent SA article "How Close Are We To The Start Of The Next Recession?" (here) I opined that we could be only a year or so from the next recession. But who knows? And, we won't know we're in it until 6 months after it starts because it takes 6 months before it's officially called. And I think the stock market typically begins to correct, or crash (read bear market), about 6 to 9 months before a recession begins.

In my "Retirement Investing Plan" article, I presented my thoughts on the next 2 years:

I expect a stock market bear to reduce current price levels by 30% + in the next 12 to 18 months, followed 6 to 9 months thereafter by a pretty deep recession. I've read recent information suggesting current CAPE valuations could be as much as 65% overvalued. That strikes me as being too high. But a 30% drop in current price seems about right and would take the S&P 500 to below 2000, from (then) current 2800. As the S&P drops below 2200 we'll begin nibbling back in and expect to once again be almost fully invested by year-end 2020.

More on that thinking below.

Now, back to Jill's graph and how it helps guide our thinking about when to get back into the market. Hereafter, I added some data points to Jill's graph that I believe tell a possible valuable story:

S&P regression showing fast and deep declines Notice that since 1900 there have been only 6 occasions when the S&P 500 rose to an over-valuation near or above 2 standard deviations (shown with black lines above. The last time was October 2018.

Note also that on each occasion when it reached that very high over-valuation of +/- 2 or more standard deviations, it falls fast and hard, not necessarily through the mean, but always close or below. The fast and hard part was new to me.

After getting to these high over-valuations, it takes only about 2 years to go down from peak to trough. Notice the short, orange, horizontal lines at the troughs.

In late 2018, the S&P 500 peaked at just under 2 standard deviations. Will that be the top? I don't know. But if history repeats, and the S&P 500 bottoms at, say, 15% over the mean of 1420, it would fall to 1630 by year-end 2020; or much lower if it breaks through the mean.

If this 1630 level by the end of 2020 possibility holds true, it must surely be accompanied by a recession and will have tremendous consequences on the 2020 election. One can therefore expect huge interference by the administration between now and then, plus dramatic action by central banks world-wide.

As noted above, my 2019 Retirement Invest Plan here calls for me to be out of the market until the bear causes a fall in the S&P 500 to 2200, or so. I may revise that lower to 2000. Why? Because “When the Facts Change, I Change My Mind. What Do You Do, Sir?”

As a final point, I'm not sure how relevant are the 2 times between 1900 and 1910 when the over-valuation was near 2 standard deviations, as the world's economies were still very much agrarian-driven then and algos weren't driving a significant part of the investing process as they are now.

Image result for “Bull markets make you money, but bear markets make you rich.”

Disclosure: I/we 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.