- The average of S&P500 for March-2020 was 2652. A 12% decline, or 325 point drop, would bring it to 2327, the end of March level of the long-term trend line.
- A recession appears to be imminent. Stocks could lose up to 50% if the S&P reaches the lower prediction band line of the long-term trend.
- If the percentage decline matches the loss during 2009-09 recession then the S&P500 could reach a low of 1560, a decline of about 35% from the current value.
- The Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE) is at a level of 24.5, almost identical to the 35-year moving average (MA35) of the CAPE of 24.3.
- The CAPE-MA35 ratio is 1.01, forecasting a 10-year annualized real return of 7.9%. Should the CAPE-MA35 ratio decline further then 10-year forward returns will be higher.
The projections in this article 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 Mar-2020, 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 not particularly low. It is still above the long-term trend line, and a reversal to the mean trend would entail a further 12% decline, possibly over a short period.
Effect of imminent recession
Over the shorter term, if the S&P-real reaches the lower prediction band line, as it did in 1920, 1932, 1942, and 1983, then the value of S&P500 could get as low as 1300. This would constitute a 50% drop from the current average March level of 2652. If the impending recession produces a similar percentage loss for equities as observed during the 2008-09 recession then the S&P500 could reach a low of 1560, all as shown in Figure-3 below.
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 March values of 24.5 and 24.3, 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 (24.5 / 24.3 = 1.01).
Currently, for the 10-year period to Mar-2030, the CAPE-MA35 ratio of 1.01 forecasts an annualized real return of 7.9% (see Figure-2 in the referenced article). For the S&P-real adjusted to the current S&P500 value this would indicating a Mar-2030 value of 5644, with upper and lower confidence values of 6300 and 5000, respectively, all as shown in Figures-2 and -3.
Forecasting returns to 2030 with the long-term trend
When extending the best fit line and the prediction bands to 2030 (Figure-3) it enables to estimate the change of S&P-real from the current level of 2652. The end of Mar-2020 value of S&P-real as indicated by the best fit line is at 2327, about 12% lower than actual average March value. In Dec-2029, the value of S&P-real should be about 4300, while the highest and lowest values shown by the prediction bands would be 8400 and 2200, respectively.
Thus the historic trend forecasts a probable gain of about 60% for S&P-real to Dec-2029. The worst case scenario would be a possible loss of about 15%, and the best outcome could be a 220% gain from the current level of 2652.
The current CAPE-MA35 ratio of 1.01 forecasts relatively high real 10-year forward returns for equities of about 7.9%. Should the market continue to decline it will provide excellent investment opportunities for long-term investors because the 10-year forward returns should become increasingly better. For example, during the 2008-09 recession the CAPE-MA35 ratio reached a low of about 0.70 in March and April 2009, and the realized real annualized 10-year return for stocks that followed was a about 14%. Similarly, for the period 1980 to 1990 when the CAPE-MA35 ratio was less than 1.00 the realized real annualized 10-year returns that followed exceeded 10%.
Monthly updates of estimated 10-year forward returns are posted at iMarketSignals.
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