The Overvalued S&P 500 Signals Low 10-Year Forward Returns: Update 8/1/2021

Summary

• The average of S&P 500 for July 2021 was 4364 (previous month 4238). This is 1894 points higher than the long-term trend value of 2470.
• The current percentage difference of S&P 500 level relative to the current long-term trend level is 77%, a value not exceeded in the recent past since 2001.
• The Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE) is at a level of 37.6. That is 50% higher than its 35-year moving average (MA35), currently at 25.1.
• The CAPE-MA35 ratio is 1.50, forecasting a 10-year annualized real return of about 3.9%. Should the CAPE-MA35 ratio increase further, then 10-year forward returns will be even lower.
• The historic long-term trend indicates a 10-year forward real annualized return of only 0.7%.

Ben Taylor/iStock via Getty Images

This is an update to our series of articles started in 2012 assessing market valuation and estimating forward stock market returns. The most recent previous update was for end of May 2021.

The projections here are partly based on Estimating Forward 10-Year Stock Market Returns using the Shiller CAPE Ratio and its 35-Year Moving Average, which is referred to as the “referenced article” further down.

What short-term stock market returns can be expected?

Nobody knows, and the best one can do is to use the historic data (which is from Shiller’s S&P series) to guide us to make estimates for the future. From the real price of the S&P-Composite with dividends re-invested (S&P-real) one finds that the best-fit line from 1871 onward is a straight line when plotted to a semi-log scale. There is no reason to believe that this long-term trend of S&P-real will be interrupted. S&P-real, updated to end of July 2021, and the best fit line together with its 95% prediction bands are shown in Figure-1. (See appendix for the equation.)

The current level of the S&P-real is 77% above the long-term trend line. A reversal to the mean trend would entail a 43% decline, possibly over a short period. But it is also possible if the upward earnings trend continues that S&P-real could reach the upper prediction band line by mid-2022. This would amount to a gain of about 13% from the current level.

Forecasting 10-year stock market returns with the CAPE-MA35 Ratio

Also shown in Figure-1 are the CAPE (which is the S&P-real divided by the average of the real earnings over the preceding 10 years) and its 35-year moving average, having end of July 2021 values of 37.6 and 25.1, respectively.

As shown in the referenced article, a superior method to the standard use of the Shiller CAPE-ratio is to predict 10-year real returns using the CAPE-MA35 ratio as a valuation measure. It is simply the value of the Shiller CAPE-ratio divided by the corresponding value of its 35-year moving average (37.6 / 25.1 = 1.50).

Currently, the CAPE-MA35 ratio of 1.50 forecasts a probable annualized real return of about 3.9% to July 2031. Based on the current S&P 500 value this would indicate an end of July 2031 value of 6387 for S&P-real, with upper and lower confidence values of 7390 and 5510, respectively, all as shown in Figures-2 and -3.

Also in Figure-3, the current level of the S&P 500 relative to the long-term trend is indicated by the line parallel to the long-term trend line. Note that since mid-2001 this relative level has never been greater than what it is now.

Forecasting returns to 2031 with the long-term trend

When extending the best fit line and the prediction bands (Figure-3), then the S&P-real end of July 2031 value would be 4679, while the highest and lowest values shown by the prediction bands would be about 9030 and 2420, respectively.

Thus the historic trend forecasts a probable gain of only about 7% (or an annualized return of 0.7%) for S&P-real from its current level of 4364 to the end of July 2031 best fit level of 4679. The worst-case scenario would be a possible loss of about 45% (annualized return -5.7%), and the best outcome could be a 107% gain (annualized return 7.5%).

Conclusion

• The current elevated level of the S&P 500 relative to the current long-term trend level warns that stocks are overvalued; and
• The current CAPE-MA35 ratio of 1.50 forecasts only a 3.9% real 10-year forward return for the S&P 500, while the long-term trend indicates a forward return of only 0.7%

One has to monitor the CAPE-MA35 ratio, because the 10-year forward returns will get lower with increasing values of this ratio. Extreme overvaluation is signaled when the CAPE-MA35 ratio exceeds a value of 1.50, which is the current value.

Updates of the estimated 10-year forward returns of the S&P 500 (Figure-2) are posted monthly at imarketsignals.com.

Appendix

The best fit line and prediction band were calculated from monthly data from Jan-1871 to July-2012. The SP-real values for the period after July-2012 are “out of sample” and were not included in the regression analysis.

The equation of the best fit line is: y = 10^(ax+b)

where: y = is the dependent variable of the best fit line. x = are the number of months from January 1871 onward. a = 0.0023112648 b = 2.02423522

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[hdwrddyo]

Been hearing that my whole life.

[Obi-Wan]

History often repeats itself, the market is full of patterns of whatever one wants to see or find. Only history makes them look genius, or foolish.....
Conclusion: the market goes up, down and sideways, but don't try to time it with any precision. Trim your losers, add to quality over time.

[Market Map]

One of the most difficult endeavours in investing has been attempt(s) at forecasting periods of subpar forward returns for the U.S. equity markets. The use of "valuation" metrics has been a popular ploy, and geopolitical events, ones that seemingly SHOULD have had an impact on the markets ( such as Covid pandemic ) failed to materially affect the markets. This may be that domestic markets and company earnings are driven be a high level of innovation, the internet / cloud based "tech revolution" that may only be in it's "5th inning", a Fed that is supportive and who is willing to "step in" and provide needed market liquidity at the slightest threat to economic growth.
However, in order to determine if and when a "systemic" market decline may be in the offing, an investor may be able to look to a robust history and repetition of phenomenon based on "data" derived from two simple variables: the four year Presidential term cycle and the "price" of the market benchmark in relation to it's "moving average".

Since 1933, negative forward market returns have correlated to periods when the SP 500 price has resided below it's moving average value ( monthly basis ) on June 30th of the given year AND those periods that have fallen within the first year of the "Presidential term cycle" ( Table 2
https://tinyurl.com/yyf48e4q ).

Systemic market declines ( declines whose duration is more than 18 months ) are rare beasts indeed. Table 1 in Appendix shows that only 11% of all July - June periods since 1933 produced double digit declines. Identifying 60% of those through a simple mechanical process is pretty reasonable.
As success in equity investing involves the uninterrupted hold of equity based assets for long periods, allowing for the compounding of dividends and corporate earnings growth, it is important to employ an objective, mechanical tactical method that intervenes, only rarely, in the holding process.

As 2021 is a first Presidential term year and with the SP500 price residing "above" it's moving average value on June 30th https://imgur.com/a/aOpRvzY , odds suggest that forward market returns will be positive.

Further, employing this simple strategy for 48 months, investment in the SP 500 produced higher returns in 94% of the 48 month periods since 1933, a statistically significant outcome. Chart 1 in Appendix
https://tinyurl.com/yyf48e4q
shows that only a handful of 48 month periods produced negative total returns, most periods of which occurred during the Great Depression. Further, investment over 96 month periods produced positive outcomes in 100% of the cases since 1933 ( Chart 2 Appendix ).

[User 47813974]

The current level of the S&P-real is 77% above the long-term trend line. A reversal to the mean trend would entail a 43% decline, possibly over a short period. But it is also possible if the upward earnings trend continues that S&P-real could reach the upper prediction band line by mid-2022. This would amount to a gain of about 13% from the current level.

Go with the latter, until the punch bowl is taken away. Plus all these trillions being spent, a god deal wil find it's way into the markets.

[Georg Vrba]

@A Catman Perhaps it will be like 2000 again. Then the S&P was 147% over the long-term trend line - not a "mere" 77%, as it is now. Three years later the S&P was 44% lower.

[User 47813974]

@Georg Vrba Article Summary: On those merits, we are not in a similar bubble today. As of August 6, 2021, the 10Y Treasury bond rate was 1.23%, which is 1.6 standard deviations below normal. Likewise, the S&P500 value of $4,437 is 2.5 standard deviations above its own respective trendline. Summed together, this gives a composite value of 0.9 standard deviations above normal, indicating that stocks are currently Fairly Valued.

www.currentmarketvaluation.com/...

[gc03]

@Georg Vrba - Thank you for the insightful article. Do you have a forecast for future returns of $QQQ?

[sgt.red.blue.red]

There are a number of companies that are producing revenue from billions of people worldwide. This was never the case in the past. Think Facebook, Google and the like. I think that anyone who tends to get too conservative and pulls back is making a mistake.

[Djreef1966]

This is going to be brutal.

[TaiPan]

So, uninspiring projected returns from indexes.

What to do to boost returns? Perhaps the Top-10 stock portfolio will provide alpha? Or perhaps a combination of trailing stops to get the investor out of SPY when a decline exceeds SPY’s normal trading range, and back into SPY when it recovers 5%-10% off a bottom? I recall testing this approach during the ten years when SPY started and ended at the same price. Pundits concluded that there investors made no money at all during this decade, but the trailing stop method managed to produce profits.