S&P 500 Crashing or Soaring?

The questions just about every investor involved with the U.S. Equity markets is asking these days are, “Will we get a significant pull back?  When is it going to happen?  How severe will it be?”

“I am talking about a veritable explosion to (deal) levels never seen before.  I think it is likely that all previous records will be broken in the next year or two.” – Jeremy Grantham (note to investors)

Percentage of Companies Beating Revenue Estimates (73%) to Date at Record High – Factset

“The recovery is not yet complete….high degree of monetary policy accommodation remains appropriate.”Janet Yellen

“We should already be worried about a steep decline. The market is highly priced, but by my standards not quite as highly priced as it was in 2007. The cyclically adjusted price-to-earnings ratio got up to 27 then. It’s 26 now. That’s close, though, and that is a cause for concern. So it might be a time to tilt one’s investments away from the U.S. Don’t get greedy.” – Robert Shiller (Forbes)

The range of commentary and high conviction projections from experienced investors and market experts seems to be ranging wildly, as it usually does, from a run up in the Dow as high as 20,000 by the end of the year to a drop of 50% over the same period.  These new forecasts and prognostications are coming out almost daily, and are based on solid factors, research and market fundamentals like P/E ratios, adjusted P/E ratios based on interest rates, CAPE (Shiller’s cyclically adjusted P/E), Technicals, Consumer Sentiment, Geopolitical factors, Central Banks, Economic growth and more.

Who, and what key factors will be proven right?

Most forecasts are based on a primary factor, or a set of factors, that compare the current numbers to historical averages.  The Price to Earnings ratio, as an example, is nearing 20 vs. the historical average of about 15, and so the market is looking overvalued.  Although it’s one of the most meaningful factors to consider for market valuation vs. historical context, it is just one factor and per the quotes above there are other significant fundamental factors that might well be justifying these valuations.  What P/E doesn’t help us determine is how likely a market correction is in the coming year and how investors will react.

As you start trying to combine factors to improve the forecast accuracy, the process starts becoming more complicated and error prone, and often times more of a “black box” model.  Traditional modelling methods struggle in trying to effectively forecast the market because the market is not driven by static factors, but rather is dynamic and new factors are always coming into play that add complexity.  Where investors have always been able to turn is to their experience.  Having been through many of these market cycles before allows investors to take the current environment and compare it to past market environments they feel are similar so they can get a gauge for what is likely to take place today.

EidoSearch technology works like the human brain does, through associative memory, and is intended to complement investor experience.  We don’t model or forecast based on a set of factors, or even dozens of factors, because this approach is limiting.  We instead use experience, or history, to tell us what is likely to happen next. Our technology does not model specifically based on using PE, 10 year trailing PE or PE adjusted for inflation.  It doesn’t matter. What matters is that we’ve seen variations of these factors historically and have seen the markets play out in these conditions and can bring those to the forefront for the investor to better understand the range of likely outcomes today.

What EidoSearch is well suited to answer is what are the likely outcomes from this point?  To accomplish this we looked at the S&P 500 price trend ranging from 1 to 5 years long, and went back to the late 1970’s to find the most similar instances of these price trends and to see how investors reacted historically.  There are some interesting details in the charts below based on shorter and longer term price trends and capturing the tail instances, but here’s the punch line:  The range of likely returns for the S&P 500 over the next 1 year, based on historical precedent, is 3.3% to 10.3%

Based on the current 5 year price trend:

• We found 9 similar historical instances in the S&P’s history
• In 5 of 9 instances, the market is up in the next 1 year and the average return is 6.0%
• Largest pull backs historically occurred starting in June 2007, Dec 1999 and March 1987

Based on the current 4 year price trend:

• We found 11 similar historical instances in the S&P’s history
• In 8 of 11 instances, the market is up in the next 1 year and the average return is 7.8%
• Largest pull backs historically occurred starting in June 2007 and August 2000 (down -21% in next 1 year)

Based on the current 3 year price trend:

• We found 15 similar historical instances in the S&P’s history
• In 10 of 15 instances, the market is up in the next 1 year and the average return is 7.9%
• Largest pull backs historically occurred starting in March 2008 (down -43% in next 1 year), April 2000 and August 1987

Based on the current 2 year price trend:

• We found 24 similar historical instances in the S&P’s history
• In 15 of 24 instances, the market is up in the next 1 year and the average return is 3.3%
• Largest pull backs historically occurred starting in December 2007 (down -39% in next 1 year), October 2000 and April 2000

Based on the current 1 year price trend:

• We found 38 similar historical instances in the S&P’s history
• In 29 of 38 instances (76%), the market is up in the next 1 year and the average return is 10.3%
• Largest pull backs historically occurred starting in September 1987, July 2000 and May 1981

Have a great week!