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Dow, S&P 500 Return Forecasts



October 05, 2009 – Comments (12) | RELATED TICKERS: JNJ , MSFT , XOM

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? ... [more]

12 Comments – Post Your Own

#1) On October 05, 2009 at 3:15 PM, portefeuille (98.81) wrote:

The earnings for the period 10/05/10-10/05/11 will likely be higher than those for the period 10/05/00-10/05/01 so the CAPE will drop more (or rise less) than the P.

an interview with Shiller on 02/23/09 on CAPE.

Shiller: Stocks Not Yet Cheap Enough for Me.

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#2) On October 05, 2009 at 3:19 PM, TMFJake (92.83) wrote:

Great article!  It's clear to me that the broad indexes are overvalued, and that there's been little differentation in the returns for individual stocks during the rally.  That supports your thesis that the best opportunity is to find the stocks that still seem to be trading at a discount.  Thumbs Up on SH (Short S&P 500 Index) and Thumbs Up on JNJ.

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#3) On October 05, 2009 at 3:25 PM, portefeuille (98.81) wrote:


The Short View

By John Authers
Published: February 25 2009 02:00 | Last updated: February 25 2009 02:00

In the short term, equity traders are desperate to see whether the S&P can hold above the level of 740, which it briefly touched last November. As stocks gained while gold sold off yesterday, in response to awful data about US house prices and consumer confidence, traders appeared to bet that share prices could hold the line for now.
Long-term measures of value are also finely poised. Take the cyclical price/earnings ratio, which compares share prices with average earnings during the past decade, rather than to the most recent year's earnings. This evens out bumps in earnings multiples caused by the profit cycle, and has proved to be a great market timing vehicle - highs and lows for this metric have overlapped almost perfectly with highs and lows for the market.
Robert Shiller, the Yale university economist, has done much to popularise the measure. According to his calculations, it makes US stocks look distinctly cheap. The cyclical p/e, at 13.38 entering this week, is below its average since 1870 of 16.34. It is also at its lowest since 1986.
However, this should not be treated as a short-term buying signal because cyclical p/es have dropped to as low as 6 at the bottom of previous bear markets. This would imply that stocks could fall 50 per cent more, before hitting bottom.


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#4) On October 05, 2009 at 3:32 PM, TMFAleph1 (91.86) wrote:


Thanks for the references; I actually saw both articles at the time of their publication.

On your first comment: My analysis doesn't rely on a single year growth rate



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#5) On October 05, 2009 at 3:39 PM, portefeuille (98.81) wrote:



March 22, 2006r

Why a long-term bet on the stock market may disappoint


What do you conclude if you see a run of blacks on a roulette wheel? Is the next colour more likely to be black than red, more likely to be red than black, or equally likely to be either? What about the stock market? If the market has enjoyed a run of exceptional returns, do you conclude that the prospects are for continued good returns, for relatively bad returns, or for either equally?

The answer for the roulette wheel is that the future is random. In its strict form, the efficient market hypothesis would suggest the same is true for stock markets. Investors do not behave as if they believe this, but rather as if a run of good or bad luck is likely to continue. Precisely because of such behaviour, the truth is the opposite: a run of relatively good returns is a reason to expect the opposite. Prices tend to overshoot in the medium term, but oscillate around a mean in the long term. Technically, as two distinguished financial economists, John Campbell of Harvard and Robert Shiller of Yale, have shown, returns demonstrate "negative serial correlation".* They revert to average valuations.

It is generally accepted that investing in stock markets is less risky in the long term than the short term. But, as Prof Campbell has written, if market returns were draws from the same random distribution every year, "though the probability of losing money falls with the length of the investment, this is offset by the increasing size of possible losses over long periods" (my emphasis) (Financial Times, May 10, 2002). Only mean reversion makes stock market investment safer over the long term.

Yet though mean reversion gives, mean reversion also takes away: sometimes it clearly gives bad news. Now is one of those times. Valuations are not as crazy as they were in 2000. But they still remain very high.

In the case of the US market, two similar measures of fundamental value — "q", or the valuation ratio (the ratio of stock market value to the replacement cost of corporate capital), and the cyclically adjusted ratio of prices to earnings — continue to show exceptionally high values by historical standards (see chart). The post-2000 market correction shows why warnings about valuation levels are worth heeding: after all, despite its recent surge, the US stock market is at the same level, in real terms, as it was about eight years ago (see chart).

As Andrew Smithers of London-based Smithers & Co shows, the US is not alone. Real returns have recently been extraordinarily high in the following stock markets: Australia, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the UK and the US.** An average of the annual real returns (in local currency) over the past 10 to 30 years, on the Morgan Stanley Capital International indices, ranges from Sweden's phenomenal 13.7 per cent to Japan's relatively poor 4.4 per cent, with the US on 8.5 per cent and the UK on 7.3 per cent (see chart). Japan is the only one of these countries not to have enjoyed higher recent returns than those enjoyed over the twentieth century as a whole. These were recorded in a wonderful book entitled Triumph of the Optimists.*** The performance of the past three decades may reasonably be called the "triumph of the super-optimists".

Improvements in the valuation of underlying assets and earnings explain most of the exceptional returns of recent decades. But there is little reason to expect valuations to rise on a secular trend. Moreover, when underlying earnings are valued relatively highly, prospective real returns have to be relatively low, by historical standards, in the absence of further rises in valuations. To put the point simply, other things being equal, a cyclically adjusted price/earnings ratio of 10 implies a real return of 10 per cent, while a ratio of 20 implies one of 5 per cent.


So where do stock markets go from here? For the short to medium term I have no idea. But we do know where they are more likely to go than not in the long term: down. Central banks have worked aggressively to reflate the post-bubble economies of the high-income countries. Even so markets are still far from their post-bubble peaks in real terms. That has certainly reduced the risks of further large falls. But the still high valuations suggest that risks of disappointment are substantial.

*Valuation Ratios and the Long-Run Stock Market Outlook: an Update, National Bureau of Economic Research Working Paper 8221, April 2001,; **Past Returns as a Guide to the Future for 15 Equity Markets, March 14 2006, (restricted distribution); ***Elroy Dimson et al, Triumph of the Optimists (Princeton University Press, 2002)


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#6) On October 05, 2009 at 3:54 PM, portefeuille (98.81) wrote:

an article from


Published in Investing Strategy on 13 July 2009

The cyclically adjusted P/E ratio is a better indicator of a cheap investment.

The conventional P/E ratio has two advantages; its ease of calculation (the current price of an asset, or market, divided by its historic earnings), and its ubiquitous use. 

Although frequently quoted as an indicator of market valuation, and potential future returns, it has an irritating flaw; in boom times when earnings are high the P/E can appear reasonable and in times of bust the P/E can appear expensive. 

Since profits revert to a mean over an economic cycle, it would appear more rational to smooth the P/E ratio to take account of this cycle and give a fairer picture of value. This is the objective of the cyclically adjusted P/E ratio (CAPE), and it has proved to be a reasonable indicator of future returns.

A long and profitable history

Warren Buffett attributes much of his success to learning investment from Benjamin Graham, the 'dean of Wall Street' and CAPE is first mentioned in his seminal work, "Security Analysis", published in 1934. In the book Graham, and co-author Dodd, recommended a CAPE using a moving average of earnings over not less than five, and preferably seven or ten years.

Try as I might, I can't find much evidence to suggest that Graham and Dodd provided extensive research into just how much better CAPE was to its alternative. In any case ,it appears to have been neglected for much of the 20th century until Yale professor Robert J. Shiller. 

Irrational exuberance

Shiller developed the concept for his analysis of markets from the early 1990s, which culminated in his ground breaking book "Irrational Exuberance". Published with impeccable timing in 2000, it predicted a decade of low returns based on CAPE. Coincidentally, he also published a book on US housing in 2005 which forecast -- you guessed it -- substantial falls in that market. Shiller is worth listening to!

The validity of using CAPE as an indicator of long-term returns was demonstrated by Shiller in a 1996 paper, "P/E ratios as Forecasters of Returns". Further evidence of the power of CAPE, this time applied to individual shares, was provided in a book by analyst James Montier, "Behavioural Investing". 

Montier and a colleague applied CAPE to buying (and short selling) low and high P/E shares from 1980 to 2005 using the MSCI World Index. The ten-year CAPE was significantly better at selecting under priced, and over priced, shares then the conventional P/E ratio. In fact, CAPE outperformed the market by 13% a year, compared to 5.5% outperformance using a one year trailing P/E.

In 2007, when the conventional P/E ratio was signalling the UK market to be fair value, renowned analyst Andrew Smithers, who uses the ten-year CAPE, argued that the UK market was 68% overvalued. Now that the market has retreated from those heights, it may well be appropriate to look at what the current CAPE is and what, if anything, it is signalling.



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#7) On October 05, 2009 at 3:57 PM, TMFAleph1 (91.86) wrote:

Thanks for the references, portfefeuille; I do consider myself a student of Robert Shiller and Andrew Smithers and I enjoy reading the financial journalism of John Authers and Martin Wolf (all four are at the top of their respective fields).



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#8) On October 05, 2009 at 3:59 PM, TMFAleph1 (91.86) wrote:

Thanks for your kind words, John and I'm glad you enjoyed the article. Fool on!

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#9) On October 05, 2009 at 4:02 PM, portefeuille (98.81) wrote:

Shiller's paper.

Price–Earnings Ratios as Forecasters of Returns: The Stock Market Outlook in 1996

two figures from that paper



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#10) On October 05, 2009 at 4:12 PM, portefeuille (98.81) wrote:

Shiller's data is here.

Have a look at this spreadsheet from that site to see the value of the earnings that are "next to drop out". Apparently the 1999 earnings were "okay". In 2011 some pretty "week" 2001 earnings will drop out.

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#11) On October 05, 2009 at 4:16 PM, portefeuille (98.81) wrote:

the figure from that spreadsheet.


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#12) On October 05, 2009 at 4:45 PM, TMFAleph1 (91.86) wrote:


Thanks for your interest. I used Shiller's spreadsheet extensively (among others) to generate the data for this article.







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