In this post I’m going to do a valuation and projection for the S&P 500 using Robert Shiller’s CAPE ratio.
I think this is worth doing on a regular basis because it gives you a good idea of where a particular market is in its valuation cycle and what sort of returns it’s reasonable to expect over the next few years.
Valuation: At 2,390 the S&P 500 is very expensive
Okay, so the S&P 500 is very expensive, but what does that actually mean?
It means that at 2,390 points, the S&P 500’s price is 27.2-times its average inflation-adjusted earnings over the last ten years (using annual data).
In other words its CAPE ratio (an improved version of the standard PE ratio) is 27.2.
Over the last century, the S&P 500’s CAPE ratio has varied between 5 and 44, with an average value of 16.9.
So at (about) 27, the current S&P 500 CAPE ratio is 59% higher than its average of (about) 17, which I think is a lot.
Another way to think about this is to look at how often the S&P 500 has been cheaper (i.e. had a lower CAPE ratio) than it is today.
In fact, the S&P 500 has been cheaper than it is today 93% of the time over the last century.
The only time the index has been more expensive than today was:
- In 1929 at the peak of the roaring 20’s, just months before the Great Depression
- In the dot-com bubble between 1996 and 2002, before declining almost 50% in the subsequent bear market
- In 2007 at the peak of the credit bubble, just before a massive 55% decline as the credit crunch exploded
If you’re interested in how the S&P 500’s CAPE has varied relative to its historic average, below is my ever-popular “rainbow chart” which shows exactly that:
This is what the chart shows:
- Black line: This is the S&P’s price
- Red band: This is where the S&P 500 would have been if it was about twice as expensive as its historic average (i.e. CAPE close to 34 rather than 17)
- Yellow band: This is where the S&P 500 would have been if was about as expensive its historic average (i.e. CAPE close to 17)
- Green band: This is where the S&P 500 would have been if it was about half as expensive as its historic average (i.e. CAPE close to 9.5 rather than 17)
CAPE ratios higher than double or less than half the historic average are classed as bubbles and depressions respectively.
As you can see, the S&P 500 is currently on its way towards bubble territory, with a long way to fall if investor sentiment turns negative.
What about the Global Financial Crisis?
Just hold your horses one dang minute, I hear you shout. What about the Global Financial Crisis?
Surely it negatively impacted average earnings over the last decade? That would reduce the “E” part of CAPE which would in turn push the CAPE ratio higher.
So perhaps the S&P 500 isn’t really expensive? Perhaps it’s just an anomaly caused by the way CAPE is calculated combined with extremely low earnings during the financial crisis?
This is a legitimate point, so let’s have a look at a chart of the S&P 500’s earnings over the last decade, using Robert Shiller’s excellent data:
As you can see, the financial crisis had a massive impact on earnings which definitely has had an impact on the CAPE ratio.
To get around this problem we can just pretend that the financial crisis never happened.
To do that I’ll just edit the earnings data so the peak earnings value of 100 in 2007 is carried right through to 2013, which is when earning finally moved back above the 100 level.
Here’s what the earnings would have looked like in this crisis-free world:
What difference does this implausibly optimistic view of the past make to my very negative view of the S&P 500?
The answer is, not a lot.
The S&P 500’s 100-year CAPE average declines from 16.9 to 16.6, hardly an earth-shattering difference.
Somewhat more impacted is its current CAPE value, which falls from 27 to 24.
If we use this more cautious CAPE ratio then the S&P 500 is now 45% more expensive than average rather than the original 59%.
And with CAPE at 24, the S&P 500 has been cheaper than it is today a mere 87% of the time rather than 93% of the time.
Another way to think about this is to think of a 100-sided die. If you rolled an 87, do you think the next roll would be higher or lower? The same idea applies to the stock market.
Okay, so the S&P 500 is expensive with or without the financial crisis.
Let’s take that optimistic CAPE of 24 and use it to make a projection of where the S&P 500 will be in one year’s time.
Projection: The S&P 500 is going down
I used to call these short-term projections forecasts, but that’s wrong because:
- A forecast is a description of a future which you think is actually going to happen, or which you think is most likely to happen.
- A projection is a description of a future based on a set of assumptions, which may or may not be likely to happen. In other words it’s a “what if” analysis.
I have absolutely no idea what the most likely short-term outcome is for the economy or the stock market, so I don’t make forecasts.
However, anybody can make assumptions about the future, so anybody can make projections.
What I’m after is a projection which gives a good indicator of the headwinds or tailwinds the market’s current valuation is creating.
So here are my assumptions, which I think are reasonable but which may or may not actually happen:
- Earnings will grow: The S&P 500’s cyclically adjusted earnings will increase by 5% in the next year, which is historically average
- The market will mean revert: The S&P 500’s CAPE ratio will close the gap between its current value (24) and its average value (16.6) by a half over the next year
Now we can make some projections using those assumptions:
- Earnings will grow: The S&P 500’s cyclically adjusted earnings will grow by 5% from 99 points in 2017 to 104 points in 2018
- The market will mean revert: CAPE will close the gap to its average value by half, moving from 24 to 20.3
With 2018 cyclically adjusted earnings at 104 points and the CAPE ratio at 20.3 we can now make a projection of the S&P 500’s value for May 2018:
- S&P 500 projection for May 2018 = 2,110
That’s a projected decline of 12%, which is not insignificant.
Remember, this is not a forecast of what will happen, but rather an indicator of the valuation headwinds the S&P 500 is current facing. If you want to forecast the future by working out what’s going to happen with Trump, China, North Korea and the combined sentiment of millions of investors then good luck!
As a final point I’ll mention the index’s projected “fair value” price, which is the price it would have a year from now if its CAPE ratio fell back to the historic average of 16.6 (again, using the optimistic assumption that the financial crisis never happened).
This simply involves multiplying the 2018 cyclically adjusted earnings of 104 by the fair value CAPE of 16.6, giving:
- S&P 500 fair value projection for May 2018 = 1,730
That’s a decline of 28% to fair value, and while such a decline isn’t guaranteed to happen, it is a very plausible scenario.
So of course I’m bearish about the S&P 500, but that doesn’t mean I wouldn’t invest in it. It just means I would be cautious and mentally prepared for the next inevitable bear market.