Thanks to a huge rally off the market's March 9 low, the
S&P 500 and the Dow have just put in their best quarter
since 1998. Bulls are coming up with all sorts of reasons to
justify the rally – and
to explain why it will continue. Meanwhile, bears have been
wringing their hands with increasing intensity. Who's right?
To answer that question, let's estimate expected medium-term
returns for both indexes
Forecasting future stock returns
In order to forecast index returns, I start by breaking
down the price return into two components: earnings growth
and price-to-earnings multiple expansion (or contraction).
The multiple I use here is the cyclically adjusted P/E ratio
(CAPE), which is calculated using average inflation-adjusted
earnings over the prior 10-year period. The CAPE originated
with the father of value investing, Ben Graham; it's since
been championed by Professor Robert Shiller of Yale. It's one
of the very few consistently predictive indicators of stock
market returns.
Index (Segment)
Index Level (Sep. 30, 2009)
CAPE: Cyclically Adjusted P/E
CAPE Long-Term Historical Average
Overvaluation
Dow Jones Industrial
Average (Megacap)
9,712.28
18.8
17.7
6.2%
S&P 500 (Broad Market/ Large
Cap)
1,057.08
18.8
16.3
14.8%
Source: Author's calculations based
on data from Dow Jones and Robert Shiller.
In order to continue, I need to make a couple of
assumptions:
The CAPE reverts to its long-term historical average.
(There's a wealth of data to back this up.)
I use a reversion period of 7 years. (Hat tip to Jeremy
Grantham's firm GMO here; this is the period they use in
their forecasts.)
With these assumptions, we can calculate the annualized
impact on index returns of an index's CAPE returning to its
long-term average over seven years. Combine that with an
estimate of long-term earnings growth, and you obtain the
expected annual price return of the index:
Index (Segment)
Long-term Earnings Growth (Bottom-Up
Estimate)*
Expected Annualized Multiple Expansion
(Annualized)
Expected Return (Annualized)
Dow Jones Industrial
Average (Megacap)
8.3%
(0.9%)
7.4%
S&P 500 (Broad Market/ Large
Cap)
10.6%
(2.3%)
8.1%
*This is a bottom-up estimate I
calculated from the long-term earnings growth estimates for
the index components.
Source: Author's calculations based on data from
Capital IQ, a division of Standard & Poor's; Dow Jones;
and Robert Shiller.
Don't forget the dividends
What of dividends, you ask? Good point
– you won't leave your income return on
the table. No fancy calculations here: I'm simply going to
use the current dividend yield as a proxy for the expected
dividend return. Combining the estimated price return and the
dividend return yields annualized total return estimates over
the next seven years:
Index (Segment)
Expected Price Return
Dividend Yield
 Total Return
(Annualized)
Dow Jones Industrial
Average (Megacap)
7.4%
2.8%
10.2%
S&P 500
(Broad Market/ Large Cap)
8.1%
2%
10.1%
Source: Author's calculations based
on data from Capital IQ, a division of Standard &
Poor's, Dow Jones and Robert Shiller.
What if things don't turn out that well?
Those sort of returns look pretty good
– perhaps
toogood. In fact, I suspect the index earnings
growth estimates have introduced an upward bias in the
results. I calculated these estimates on a bottom-up basis as
a weighted average of the consensus long-term EPS growth
estimates of the index components. One should treat the
prognostications of sell-side analysts with skepticism at the
best of times; during this year's stock rally, I've become
particularly concerned that analysts are wearing rose-tinted
glasses.
As a counterpoint, let's imagine that things work out more
like they have over the last 80 years. Instead of relying on
analysts' crystal balls, let's use long-term average earnings
growth rates as our forecast of future growth rates (the
long-term average growth rates in 10-year average earnings
for the S&P 500 and Dow are 6.2% and 3.9%, respectively).
Once I give my spreadsheet a whir, this is how the numbers
pan out:
Index (Segment)
Expected Price Return
Dividend Yield
 Total Return
(Annualized)
Dow Jones Industrial
Average (Megacap) Continued... |