By Mark Hulbert
Many analysts overlook one crucial factor when estimating the stock market’s future return: Changing valuations.
That’s surprising, since you would otherwise think that valuations — how much investors are willing to pay for a dollar of earnings, dividends, book value, cash flow, etc. — would be the centerpiece of any such estimation. But analysts all too often focus instead on factors such as the growth rate of earnings.
Those factors are important too. But in this column — my monthly update of eight valuation ratios with good long-term records — I am focusing on what it would mean if these ratios receded from their current extreme overvaluation.
That’s timely because, as you will see from the table at the end of this column, all eight of these ratios are at or close to historical extremes. What would the stock market’s return be over the next five years if those ratios retreated even slightly toward their historical means?
To answer that question, I will focus on the P/E ratio made famous by Yale University finance professor (and Nobel laureate) Robert Shiller, known as CAPE (for cyclically adjusted price earnings ratio). I would reach profoundly similar conclusions regardless of which of the eight ratios on which I focus.
To calculate the effect of different CAPE ratios in five years’ time, I had to make two assumptions. The first is the growth rate of the Consumer Price Index over the next five years. I chose the five-year break-even inflation rate, which currently is 2.35%.
The second assumption is the growth rate of the S&P 500’s /zigman2/quotes/210599714/realtime SPX +2.39% nominal earnings per share. I assumed (per FactSet estimates ) that EPS would grow 23.6% in calendar 2021, and for the four subsequent years at a 14.1% rate (which is State Street’s estimate for the S&P 500’s average three- to five-year growth rate ).
Notice that these earnings growth rate assumptions are generous. To put them in perspective, consider that they are far higher than EPS’ average growth rate for the 10 years through year-end 2019. If a recession were to occur at any time between now and the end of 2025, a not-insignificant possibility, then EPS’ five-year growth rate would be far lower.
Given these assumptions, it’s a matter of straightforward arithmetic to calculate the S&P 500’s annualized return through year-end 2025, given various CAPE levels at that time. The result of those calculations appears in the table below.
Notice that in order for the stock market to produce anything close to its long-term historical average return, the CAPE will need to remain at its current high level —higher than 95% of all monthly readings over the past 50 years. If the CAPE declines even modestly, then the next five years will experience only modest gains or outright losses.
For example, if the CAPE were to retreat only half way to its historical mean — to the 75 percentile from its current 95 percentile — then the S&P 500’s annualized price-only return over the next five years will be barely positive before inflation, and negative after inflation.
This underlines the importance of taking valuation changes into account when forecasting the future. It’s possible that earnings will grow at a robust, double-digit annualized rate over the next five years and the stock market still will go nowhere — or even decline.
Current status of valuation indicators
For a full description of how each of the indicators in the table below is calculated, please refer to my Oct. 30 column .
Scroll the table to see all the data.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com .