More Stock-Market Analysis (II)

Today’s trading on U.S. stock markets left the Wilshire 5000 Total Market Full-Cap index 17 percent below its September high. How low will the market go? When will it bounce back? There’s no way to know, which is the main message of “Shiller’s Folly” and “More Stock-Market Analysis“.

Herewith are three relevant exhibits based on the S&P Composite index as reconstructed by Robert Shiller (commentary follows):

In the following notes, price refers to the value of the index; real price is the inflation-adjusted value of the index; total return is the value with dividends reinvested; real total return is the inflation-adjusted value of total return.

  • The real price trend represents an annualized gain of 1.8 percent (through November 2018).
  • The real total return trend represents an annualized gain of 6.5 percent (through September 2018).
  • In month-to-month changes, real price has gone up 56 percent of the time; real total return has gone up 61 percent of the time.
  • Real price has been in a major decline about 24 percent of the time, where a major decline is defined as a real price drop of more than 25 percent over a span of at least 6 months.
  • The picture is a bit less bleak for total returns (about 20 percent of the time) because the reinvestment of dividends somewhat offsets price drops.
  • Holding a broad-market index fund is never a sure thing. Returns fluctuate wildly. Impressive real returns (e.g., 20 percent and higher) are possible in the shorter run (e.g., 5-10 years), but so are significantly negative returns. Holding a fund longer reduces the risk of a negative return while also suppressing potential gains.
  • Long-run real returns of greater than 5 percent a year are not to be scoffed at. It takes a lot of research, patience, and luck to do better than that with individual stocks and specialized mutual funds.

More Stock-Market Analysis

I ended “Shiller’s Folly” with the Danish proverb, it is difficult to make predictions, especially about the future.

Here’s more in that vein. Shiller uses a broad market index, the S&P Composite (S&P), which he has reconstructed back to January 1871. I keep a record of the Wilshire 5000 Full-Cap Total-Return Index (WLX), which dates back to December 1970. When dividends for stocks in the S&P index are reinvested, its performance since December 1970 is almost identical to that of the WLX:

It is a reasonable assumption that if the WLX extended back to January 1871 its track record would nearly match that of the S&P. Therefore, one might assume that past returns on the WLX are a good indicator of future returns. In fact, the relationship between successive 15-year periods is rather strong:

But that seemingly strong relationship is an artifact of the relative brevity of the track record of the WLX.  Compare the relationship in the preceding graph with the analogous one for the S&P, which goes back an additional 100 years:

The equations are almost identical — and they predict almost the same real returns for the next 15 years: about 6 percent a year. But the graph immediately above should temper one’s feeling of certainty about the long-run rate of return on a broad market index fund or a well-diversified portfolio of stocks.


Related posts:
Stocks for the Long Run?
Stocks for the Long Run? (Part II)
Bonds for the Long Run?
Much Ado about the Price-Earnings Ratio
Whither the Stock Market?
Shiller’s Folly

Shiller’s Folly

Robert Shiller‘s most famous (or infamous) book, is Irrational Exuberance (2000). According to the Wikipedia article about the book,

the text put forth several arguments demonstrating how the stock markets were overvalued at the time. The stock market collapse of 2000 happened the exact month of the book’s publication.

The second edition of Irrational Exuberance was published in 2005 and was updated to cover the housing bubble. Shiller wrote that the real estate bubble might soon burst, and he supported his claim by showing that median home prices were six to nine times greater than median income in some areas of the country. He also showed that home prices, when adjusted for inflation, have produced very modest returns of less than 1% per year. Housing prices peaked in 2006 and the housing bubble burst in 2007 and 2008, an event partially responsible for the Worldwide recession of 2008-2009.

However, as the Wikipedia article notes,

some economists … challenge the predictive power of Shiller’s publication. Eugene Fama, the Robert R. McCormick Distinguished Service Professor of Finance at The University of Chicago and co-recipient with Shiller of the 2013 Nobel Prize in Economics, has written that Shiller “has been consistently pessimistic about prices,”[ so given a long enough horizon, Shiller is bound to be able to claim that he has foreseen any given crisis.

(A stopped watch is right twice a day, but wrong 99.9 percent of the time if read to the nearest minute. I also predicted the collapse of 2000, but four years too soon.)

One of the tools used by Shiller is a cyclically-adjusted price-to-earnings ratio known as  CAPE-10 . It is

a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten [previous] years of earnings … , adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.

CAPE-10, like other economic indicators of which I know, is a crude tool:

For example, the annualized real rate of price growth for the S&P Composite Index from October 2003 to October 2018 was 4.6 percent. The value of CAPE-10 in October 2003 was 25.68. According to the equation in the graph (which includes the period from October 2003 through October 2018), the real rate of price growth should have been -0.6 percent. The actual rate is at the upper end of the wide range of uncertainty around the estimate.

Even a seemingly more robust relationship yields poor results. Consider this one:

The equation in this graph produces a slightly better but still terrible estimate: price growth of -0.2 percent over the 15 years ending in October 2018.

If you put stock (pun intended) in the kinds of relationships depicted above, you should expect real growth in the S&P Composite Index to be zero for the next 15 years — plus or minus about 6 percentage points. It’s the plus or minus that matters — a lot — and the equations don’t help you one bit.

As the Danish proverb says, it is difficult to make predictions, especially about the future.