Is the Stock Market Overvalued? – Update July 2019, and 10-Year Real Forward Return Estimate

  • The average of S&P 500 for Jun-2019 was 2,890. A 20% decline from this level would bring it to the Jan-2020 level of the long-term trend line.
  • The Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE) is at a relatively high level of 28.9, and the CAPE’s 35-year moving average (MA35) is at 23.9.
  • The CAPE-MA35 ratio is 1.21, forecasting a 10-year annualized real return of 6.2%. This would indicate that for long-term investors the S&P 500 is currently not overvalued.
  • Investing in equities for the long-haul when the CAPE-MA35 ratio is below 1.30 should produce reasonable returns as this level of the ratio does not signifies overvaluation of the market.

This is a follow-up article to 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.

Over the last 10 years, since March 2009 the S&P500 with dividends has gained a real 290%. So what further gains can we expect, if any?

Will the bull market continue?

Nobody knows, and the best we 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 June 2019, and the best fit line together with its 95% prediction bands are shown in Figure-1. (See appendix A for the equation.)

The current level of the S&P-real is above the long-term trend line, and a reversal to the mean trend would entail a 20% decline.

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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 June values of 28.9 and 23.9, respectively.

As discussed 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, which is simply the value of the Shiller CAPE-ratio divided by the corresponding value of its 35-year moving average (28.9 / 23.9 = 1.21).

Currently, for the 10-year period to Jun-2029, the CAPE-MA35 ratio of 1.21 forecasts an annualized real return of 6.2%. For the S&P-real referenced to the current S&P 500 value this would indicating a Jun-2029 value of 5,275, with upper and lower confidence values of 6,000 and 4,600, respectively, all as shown in Figures-2 and -3.

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What losses can we expect?

When extending the best fit line and the prediction bands to 2030 (Figure-3) it enables us to estimate the change of S&P-real from the current level of about 2,890. In Jan-2020 the value of S&P-real as indicated by the best fit line should be about 2,340, about 20% lower than where it is now.   In Dec- 2028, the value of S&P-real should be about 4,130, while the highest and lowest values shown by the prediction band would be 7,980 and 2,140, respectively.

Thus, the historic trend forecasts a probable gain of about 45% for S&P-real to Dec-2028. The worst scenario would be a possible loss of about 25%, and the best outcome would be a 180% gain from the current level.

Conclusion

The current relatively high CAPE ratio of 28.9 and the elevated level of S&P-real relative to its long-term trend line suggest that the S&P 500 could decline over the shorter term. However, the current CAPE-MA35 ratio of 1.21 still forecasts reasonably good 10-year forward returns for the stock market.

Large drawdowns are always possible during a 10-year look-ahead period. Investments can be protected by following signals from various market-timing models at iMarketSignals. It is also important to know when a recession is looming, because stocks usually do poorly during recession periods. Our Business Cycle Index should provide early warning of an oncoming recession.

Appendix A

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)   

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

 

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