Robert Shiller was on CNBC New Year’s Eve to make his forecast for the S&P 500 index in 2020. His best guess is a 1430 level which works out to 14% price appreciation over the next ten years or 1.3% annually. Taking no issue with the P/E multiple he uses but only analyzing the earning forecast I believe he may be slightly optimistic. He arrives at the 1430 level as follows:

- Real earnings in 2020 are 78.20 per share. He is assuming real earnings growth of 1.5% per year which is the long-term average.
- CAPE (cyclically adjusted price earnings) or PE10 ratio of 15. This is the 1890-1990 average P/E. He excludes the “bubble” years of 1990-2010 which would inflate the average P/E to 16.
- Annual inflation of 2%
- Result is a 1430 level on the S&P.

This is hardly an overwhelmingly optimistic forecast but Shiller – who does these long-term forecasts better than most – might even be a little sanguine when it comes to his earnings forecast. That is because he seems to be applying the historical 1.5% real growth rate to earning that are currently inflated due to elevated profit margins.

If we normalized profit margins to their post-2000 average of 6.8% (TTM average S&P 500 margins are 7.2%) and then apply 1.5% growth we come up with 2020 real earnings of 73.8. Adding 2% inflation and using the 15 multiple we would get a S&P 500 value in 2020 of not 1430 but 1370. This works out to a 9% increase over 10 years or 0.9% annually.

Using the corporate profit to GDP analysis I have done in the past allows us to calculate 2020 earnings via another method. When corporate profits are above 7% of GDP (the current level is 8.3%) the average 10 year real growth in profits is only 1.1% annually. This below average growth is due to profit margins being one of the most mean reverting metrics in finance. Using the 1.1% growth rate from current levels we get real 2020 earnings of 75.4. Applying the same 2% inflation target 15 PE multiple we get an S&P 500 value of 1392. An 11% total 10 year increase or 1.0% annually.

The bottom line is that while Shiller’s 2020 earnings forecast may be a bit optimistic using 2 different methods lends similar, while slightly lower results. The real key to forecasting the 2020 S&P level is nailing the P/E multiple which is much harder than forecasting earnings. I am perfectly happy using Shiller’s suggested P/E of 15 as the P/E is typically driven by interest rates and inflation both of which are low and stable. Interest rates are still near historical lows and inflation has been relatively stable for some time. An increase in rates and a decrease in inflation stability, both of which seem highly likely, should drive the P/E multiple closer to 15 than its current level of 23.4 – a level higher than all but 13% of monthly occurrences since 1900.

With the S&P 500 likely to produce below average returns over the next decade I would suggest the following:

- A good, active investing strategy is likely to outperform in this environment. With the S&P 500 essentially stuck in a trading range for the next decade buy and hold will disappoint. If you have the time and ability, use the strategy that best works for you.
- Diversify among asset classes. Commodities may outperform one year, emerging markets the next and debt the following. Don’t limit your investments in this environment to an equity index.
- Rebalance. According to Ed Easterling at Crestmont Research (pdf) the impact of rebalancing (selling a portion of your winning asset classes and buying the under performing ones which later become over performing assets) annually versus bi-annually (every other year) is a 1.3% benefit annually during bear markets and a 0.3% loss during bull markets.

Please see the entire interview with Robert Shiller below.

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Great article. I think forecasters are way too optimistic about future returns. Based on every single metric besides P/B the stock market is very over-valued. The only other metric that shows the market undervalued is forward PE, but no one knows if earnings will really grow that much in 2011. Remember what the forecasts were for 2008? Every single bank forecasts higher earnings and higher S&P (than in 07) then we had Bear Sterns, Lehman and the near collapse of the world economy.

Shiller is a voice of reason in times where everyone seems to be a perma-bear.

Thanks Jacob. I definitely think earnings are set to disappoint over the next few years due to a normalization in profit margins. This coupled with a decrease in the P/E ratio due to higher interest rates, inflation or deflation (chances are we move away from price stability) and the general P/E cycle set the table for disappointing returns over the next 10 or so years.

Doug Short had an interesting observation about the P/E cycle in his piece today :

“A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits.”

One factor Schiller overlooks is non-US earnings. This is not a new issue, but it has been slowly gaining for many years. I believe that about 70% of the S&P 100’s earnings come from ex-US. Since most of the world has GDP growth in excess of the US, this is a positive for valuation.

Another factor his model does not account for is investment alternatives to stocks. Bond yields are at some of the lowest levels in the last 50 years. This should also put an upward bias to US stock P/Es. I realized that many people think that yields will rise. However, that argues to a stock/bond arb rather than a pure negative on stocks.

Thanks for the comment Burt.

We have gone through phases of increased/decreased globalization before however the long-term real growth rate has remained fairly consistent. I would guess more money has been lost than gained thinking “it’s different this time”.

Rates are low now but may not be in 10 years. As I stated above due to current optimal conditions in rates and inflation I think we are unlikely to be operating under the same conditions in ten years and would therefore bet the P/E in 2020 is closer to 15 than 23.

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I’m not saying that it’s different this time. I’m just saying that if you are comparing S&P profits to US GDP then it makes sense to use US profits as the comparison. If you do this, you will find that the upward trends in the valuation graphs since the 1950s disappear.

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First off, I think you are right that Shiller is probably being overly optimistic. One reason is his assumption that the real long term growth rate is 1.5%. I get lower growth rates than that when I look at the data. Do you know where he gets that number?

Thanks!

He is using the growth rate in real earnings from 1900-Jun 2010. 1900 real EPS = 13.31 and Jun ’10 EPS = 67.41. Works out to just under 1.5%.