The S&P 500 has had a much stronger post financial crisis bull market than the FTSE 100. However, as a consequence the US large-cap index is now much more expensive than its UK counterpart.
Bull markets are nice, but they do have a nasty habit of ending
From a low of just under 700 points in March 2009, the S&P 500 now stands close to 2,000. That’s a gain of almost 200% even without including dividend income.
In contrast the FTSE 100 has increased by less than 100%, going from around 3,500 to 6,200 today.
To a large extent bull markets are driven by confidence and expectations of short-term gains. As long as the bull market keeps going up investors keep adding new money into the market, which drives the market upwards even further.
But confidence (and greed) can only take a market so far and more recently the S&P 500 has ground to a halt.
Returns over the last year or so have been flat and so perhaps this is a good time to look at which way the market might go if confidence cannot be relied upon to drive it ever upwards.
S&P 500 valuation: Expensive relative to historic norms
As long-time readers will know, I like to value indices by using Robert Shiller’s CAPE ratio (Cyclically Adjusted PE), which compares an index’s current price to the ten-year average of its inflation adjusted earnings.
It’s very similar to the PE ratio, but much more stable (thanks to the smoothing effect of using ten-year average earnings instead of just last year’s earnings) and with a much closer connection to long-run future returns.
The chart below is my attempt to visualise the range of values that the CAPE ratio can take as the S&P 500’s price moves up and down relative to its average earnings:
Here are a few of the key ideas underlying this rainbow chart:
- Over the past 100 years the S&P 500’s CAPE ratio has had a median (middle) value of 16
- The CAPE ratio spends most of its time between about half and double its median value, i.e. between 8 and 32
- It is reasonable to describe the S&P 500 as being in a bubble when CAPE is above 32 and in a depression when it is below 8
- The higher (or lower) the CAPE ratio the more likely it is that it will decline (or rise) over the medium-term, back towards its median value, i.e the ratio is mean-reverting
So where are we today?
With the S&P 500 index close to 2,000 its CAPE ratio is 25; that’s some 56% above the long-run median value of 16.
One way to think about this is to see the S&P 500 as being about halfway between normal (CAPE of 16) and bubble territory (CAPE of more than 32).
This relatively high valuation also shows through in the index’s dividend yield. Currently it is just 2.2%, which is a very long way short of the 4% available from the FTSE 100 (with the FTSE 100 at 6,200).
So the S&P 500 is expensive relative to historic norms, but what does that mean for future returns?
S&P 500 forecast: My model suggests a small decline is likely
Before I make my one-year forecast for the US large-cap index, I just want to make something very clear:
I have no idea where the market will be in one year’s time, and neither does anybody else.
Rather than trying to guess exactly where the market will be, this forecast is an estimate of the market’s expected value, i.e. the average value of the S&P 500 a year from now if we could re-run the next year a thousand times over.
This forecast will be based on the following assumptions:
- The cyclically adjusted earnings of the S&P 500 will increase by 4% over the next year (as they have done on average over the past 30 years)
- The CAPE ratio will move halfway back towards its long-run median of 16 (due to its mean-reverting nature, see this FTSE 100 forecast for a bit more about this idea)
The increase in cyclically adjusted earnings would take those earnings from 80 index points today to 83.3 a year from now, while a 50% move back towards the long-run average for the CAPE ratio would leave the ratio at 20.5.
Putting those two together (by multiplying the earnings of 83.3 by the expected CAPE ratio of 20.5) gives the following:
My forecast value for the S&P 500 in March 2017 is 1,700
As I mentioned above, I don’t actually think the index will be at 1,700 next March. This forecast is just a best guess at where the index will be, much like 3.5 is the best guess for the roll of a die, even though the odds of actually rolling a 3.5 are zero.
So with the S&P 500 currently close to 2,000, that forecast suggests an “expected” decline of around 15% over the next year, which sounds entirely reasonable to me, especially given the index’s 200% run up following the financial crisis.