The S&P 500 has produced fantastic results for investors since the Great Financial Crisis. However, largely because of those rapid gains the US large-cap index is more likely to produce below average or even negative returns over the next few years.
The S&P 500 is expensive relative to historic norms
Today the S&P 500’s price of 2,176 points is about 27.5 times its average inflation-adjusted earnings of the last ten years (a ratio which is usually known as the Cyclically Adjusted PE or CAPE ratio).
However, the average CAPE ratio for the S&P 500 over the past 100 years is just under 17.
If we assume that CAPE will have an average value close to 17 in the future (which is a reasonable assumption) then the S&P 500 today could be overvalued by as much as 63%.
Of course there is no law which states that the S&P 500’s CAPE ratio must always be precisely equal to its long-term average. In fact the index and its CAPE ratio can swing about wildly, as any equity investor will know (and the same obviously applies to UK indices such as the FTSE 100).
Generally this near-random walk is bound within a range, with CAPE staying between half and double its long-term average almost all of the time.
With the S&P 500’s average CAPE sitting just below 17 that range extends from about 8.5 to 34, as I’ve tried to illustrate with the chart below:
Note that the CAPE “rainbow” moves steadily upwards thanks to inflation plus the real growth of those 500 companies.
A high CAPE ratio suggests low future returns (and vice versa)
When an index and its CAPE ratio are towards the lower end of their normal range the odds grow ever stronger that the index will outperform over the next few years.
This happy outcome occurs because of the wonders of valuation mean reversion, i.e. that the CAPE ratio will almost certainly revert back to its historic average given enough time.
Within the lifetime of most investors today, such a low point was reached most notably during the late 70s and early 80s. Investors were witnessing – according to Business Week magazine – “The death of equities”.
The market had gone nowhere but sideways or down for years and so the mood was as glum as that magazine headline suggests. But the incredibly low CAPE ratio of seven suggested that the future was fantastically bright for those brave enough to ignore the crowd.
And CAPE was right: The slump of the early 80s was one of the great buying opportunities of the last century.
At the other end of the scale the dot-com bubble sent the S&P 500 and its CAPE ratio soaring into uncharted territory; “There be dragons” seems oddly appropriate.
The extreme optimism of the 90s eventually led some to ask “What if we are just at the beginning of the beginning of a long wave of ultraprosperity?”
That statement is looking ever more true as the years go by (at least for some) but material prosperity does not mean that the stock market or companies in general can beat inflation by 20% per year for the rest of eternity. Even vaguely efficient global capital allocation will make sure of that.
A much less exciting but much more likely outcome for investors in the 90s was that the S&P 500’s CAPE ratio would revert from its record high of 44 back towards its average mid-teen value at some point during the 2000s.
And CAPE was right again: The boom of the late 90’s was one of the worst buying opportunities of the last century.
Today the S&P 500’s CAPE ratio is high, but not as insanely high as it was in the dot-com bubble. However, with a CAPE ratio of 27.5 that ratio is higher than it’s been for more than 95% of the last 100 years.
One entirely reasonable way to describe the S&P’s current situation is that there is about a 5% chance that its CAPE ratio will go up over the next few years and about a 95% chance that it will decline.
Another way to think about the S&P 500’s future is to do a one-year forecast.
S&P 500 forecast: A decline is likely over the next year
The heading above kind of gives the game away but here are the details. First of all we need to know a few things:
- The S&P 500 currently sits at 2,176
- Its cyclically adjusted earnings are 79.2
- Its CAPE ratio is 27.5
- CAPE’s 100-year average is 16.8
Historically the S&P 500’s cyclically adjusted earnings have grown by about 5% per year.
If we assume that 5% growth rate occurs over the next year then its cyclically adjusted earnings will grow from 79.2 to 83.2.
If we also assume that CAPE will close the gap to its mean value by half over the next year (unlikely to actually happen but it’s still a reasonable assumption) then the S&P 500’s CAPE ratio in one year will be 22.2.
By multiplying those two numbers (83.2 and 22.2) we can calculate an expected value for the S&P 500 in one year’s time (the expected value is the average value you might expect over a large number of alternate futures). And so:
- The expected value for the S&P 500 in one year’s time is 1,843
This represents a decline of 15% from today price and so, somewhat obviously, I don’t think the S&P 500 index is an attractive investment at its current level.
Some final thoughts:
Passive investors: You shouldn’t worry about the S&P 500 because you should be widely diversified across many different countries and asset classes, regardless of where you live.
Active investors: There are almost certainly many attractively valued stocks within the S&P 500. However, you should be aware that an expensive index is likely to be a drag on the returns of most stocks in the index as it mean reverts, and that applies even to those stocks that are already attractively valued.
Data: You can get very long-term CAPE-related data for the S&P 500 index from Robert Shiller’s website.