"Those who have knowledge, don't predict. Those who predict, don't have knowledge." - Lao Tzu 600BC - 531BC
'Tis the season for 2011 prognostications, the papers and blogosphere are filled with the hot air of market prognosticators pontificating on the future, which of course none of us know. This annual ritual of predicting what the new year will bring is relatively harmless, assuming investors take it as entertainment and not investment advice. I want to reiterate this point again, my predictions are for entertainment, we manage money based on what is happening in the markets, not on what we or someone else thinks is going to happen.
I've always been fascinated by magicians, their slight of hand, and their ability to make us see what they want us to see. This art of illusion is also practiced in the investment community. So called guru's bring out the charts and graphs, and try and show you what will happen if you only believe. But reality is a very different beast. The December 20 issue of Barron's brings together 10 market strategists and gets their opinion on 2011. Last year at this time these seers forecast an average gain in the S&P 500 of 5%, so far the actual gain is about 12.7%, so they only missed it by 154%. This year, emboldened by 2010's strong advance, they are forecasting the S&P 500 to gain an additional 8.5%.
I'm not trying to diss these gurus, annual forecasts are incredibly difficult, there are just too many short-term factors that can derail the most diligent prognostications. I can draw up perfectly plausible scenarios that show why the S&P 500 should fall 10% or more (chief on the list would be a State's near default and subsequent bailout by the lowly US taxpayers), or why it might rise 10% or more (Congress repeals Obamacare and makes serious cuts in spending). But again, the reality is, no one knows!
If you are at all interested in a serious forecast, let me let you in on a little magicians secret formula. I've developed a simple excel spreadsheet that will tell you exactly what return you will get by investing in the stock market over the next ten years. Stop laughing, I am serious here. This spreadsheet is 100% accurate, all you have to do is provide me with two inputs; 1) what will the annualized earnings per share growth be over the next ten years, and 2) what will the Price-to-Earnings (PE) ratio be at the end of our ten year period. That's it, two simple inputs and you too will be a market guru.
Seriously, let's take a closer look at this. The markets future returns are made up of several factors; the current price, the current earnings and future earnings growth, the current dividends and future dividend growth, and lastly what investors will be willing to pay for that earnings and dividends ten years hence. If we break this down you can see that we already know some of the variables.
First, the starting price is today's S&P 500 $1,256.77.
Current year estimated earnings are $71.86.
Which gives us a starting Price-to-Earnings (PE) ratio of 17.49x (1256.77/71.86).
And, lastly our current dividend yield is 1.87%.
Now that we have a starting place we can attack the unknowns. First, ten year annualized earnings growth. Over the last 82 years S&P 500 earnings have grown at about a 6% annualized rate, do you think earnings growth over the next ten years will be greater than, or less than 6%? Clearly there are numerous variables that will impact your decision, but the most important one is your estimation of GDP growth and inflation. For brevities sake lets assume that since the US and most of the developed world is caught in the early stages of a generational de-leveraging earnings growth will be less that the debt fueled historic 6%. Let's say 4%-5%.
Next is the hard part, what will investors be willing to pay for those earnings and dividends in the year 2020? A lot goes into PE ratios; expected earnings growth, expected inflation, and expected interest rates are the main factors. The higher the earnings growth, the lower the inflation and interest rate expectations, the higher the PE ratio. And conversely, the lower the earnings growth, and the higher the inflation and interest rate expectations, the lower the PE ratio. Since it is impossible to know with any semblance of certainty, what these variables will be in 2020, we use history as a guide. The average PE ratio over the last 82 years has been 15.95x. We are currently at 17.49x. At earnings peaks the PE ratio drops to 12.94x, and at earnings troughs the PE ratio is at 18.82x. Now what do you think will happen to the current PE ratio of 17.5x over the next ten years, will it expand or contract? Your guess is as good as mine, but if we assume it contracts a bit from 17.5x to the historic average of 16x, then we can expect an annualized total return of 4.95%-5.94% between now and 2020. Not outstanding, but not horrible either in a world of 3%-4% interest rates. Now this is nominal total return, before inflation. If we assume inflation of 2%-3%, then our real return falls to 2.5%-3.5% range.
That's it, that's how simple it is to become a stock market guru.
Be careful out there, and keep the lights on,
Chris Wiles, CFA
412-260-7917
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This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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