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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? To answer that question, let's estimate expected medium-term returns for both indexes.

Forecasting future stock returns
To forecast index returns, I start by breaking down the price return into two components: earnings growth and price-to-earnings multiple expansion (or contraction). The multiple I use here is the cyclically adjusted P/E ratio (CAPE), which is calculated using average inflation-adjusted earnings over the prior 10-year period. The CAPE originated with the father of value investing, Ben Graham; it's since been championed by Professor Robert Shiller of Yale. It's one of the very few consistently predictive indicators of stock market returns.

Index (Segment)

Index Level (Sept. 30, 2009)

CAPE: Cyclically Adjusted P/E

CAPE Long-Term Historical Average


Dow Jones Industrial Average (Megacap)





S&P 500 (Broad Market/ Large Cap)





Source: Author's calculations based on data from Dow Jones and Robert Shiller.

In order to continue, I need to make a couple of assumptions:

The CAPE reverts to its long-term historical average. (There's a wealth of data to back this up.)

I use a reversion period of seven years. (Hat tip to Jeremy Grantham's firm GMO here; this is the period they use in their forecasts.)

With these assumptions, we can calculate the annualized impact on index returns of an index's CAPE returning to its long-term average over seven years. Combine that with an estimate of long-term earnings growth, and you obtain the expected annual price return of the index:

Index (Segment)

Long-term Earnings Growth (Bottom-Up Estimate)*

Expected Annualized Multiple Expansion

Expected Return (Annualized)

Dow Jones Industrial Average (Megacap)




S&P 500 (Broad Market/ Large Cap)




*This is a bottom-up estimate I calculated from the long-term earnings growth estimates for the index components.
Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's; Dow Jones; and Robert Shiller.

Don't forget the dividends
What of dividends, you ask? Good point -- you won't leave your income return on the table. No fancy calculations here: I'm simply going to use the current dividend yield as a proxy for the expected dividend return. Combining the estimated price return and the dividend return yields annualized total return estimates over the next seven years:

Index (Segment)

Expected Price Return

Dividend Yield

 Total Return (Annualized)

Dow Jones Industrial Average (Megacap)




S&P 500

(Broad Market/ Large Cap)




Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's, Dow Jones and Robert Shiller.

What if things don't turn out that well?
Those sort of returns look pretty good – perhaps too good. In fact, I suspect the index earnings growth estimates have introduced an upward bias in the results. I calculated these estimates on a bottom-up basis as a weighted average of the consensus long-term EPS growth estimates of the index components. One should treat the prognostications of sell-side analysts with skepticism at the best of times; during this year's stock rally, I've become particularly concerned that analysts are wearing rose-tinted glasses.

As a counterpoint, let's imagine that things work out more like they have over the last 80 years. Instead of relying on analysts' crystal balls, let's use long-term average earnings growth rates as our forecast of future growth rates (the long-term average growth rates in 10-year average earnings for the S&P 500 and Dow are 6.2% and 3.9%, respectively). Once I give my spreadsheet a whir, this is how the numbers pan out:

Index (Segment)

Expected Price Return

Dividend Yield

 Total Return (Annualized)

Dow Jones Industrial Average (Megacap)




S&P 500 (Broad Market/ Large Cap)




Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's, Dow Jones and Robert Shiller.

These returns are a lot less enticing, especially for the S&P 500. Furthermore, these are nominal returns -- inflation will be collecting its excise on the purchasing power of your assets along the way. If this scenario came to pass, and assuming current expectations for inflation, the real return on the S&P 500 would be just 2.3%. My hunch is that actual returns will fall somewhere in the range between our "Analyst Estimate" and "Historical Precedent" scenarios (although probably closer to the bottom end of the range):


Expected Annual Total Return – Range*

Dow Jones Industrial Average (Megacap)

8.9% ± 1.1%

S&P 500 (Broad Market/ Large Cap)

7.2% ± 3.3%

*Note that the true range of returns is subject to uncertainty beyond that on the rate of earnings growth. Consequently, it's wider than the range displayed.

For stock pickers, the range of returns for stocks in these indices is bound to be much wider. I've written multiple times that the stocks of high-quality companies appear undervalued right now; in fact, within the blue-chip Dow index, there is only one stock – Coca-Cola (NYSE: KO  ) -- that trades at a CAPE that is higher than that of the S&P 500. As the following table shows, some of the stock's brethren look very attractive right now:


Cyclically Adjusted P/E Multiple*

Chevron (NYSE: CVX  )


ExxonMobil (NYSE: XOM  )


Pfizer (NYSE: PFE  )


Microsoft (Nasdaq: MSFT  )


Johnson & Johnson (NYSE: JNJ  )


JPMorgan Chase (NYSE: JPM  )


*As of Sept. 30, 2009. Note that the CAPE calculations here aren't exactly consistent with those for the indexes.
Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

The outlook for the next 12 months
If you are like most investors, seven years may seem like a long time -- you want to know where stocks will be at the end of this quarter. Unfortunately, valuation isn't a good indicator of stock returns in the short or medium term; however, one can certainly make some informed guesses based on the data at hand.

Between the two indexes, the S&P 500 is the riskier proposition in the short term, because of its overvaluation. If the S&P 500 went from being 15% overvalued to 20% undervalued -- for the statistics wonks, that's less than a one standard deviation move -- that would equate to a 30% loss, putting the S&P 500 at 737. I'd estimate the odds of a decline of that magnitude or greater over the next 12 months are better than 1 in 5.

Final recommendations
If you're an index investor, your medium- to long-term prospects aren't bad, but they aren't stellar, either. Expect to earn returns that lag historical averages. In that respect, it is no time to be overweight U.S. equities -- particularly since I think there are good odds that short-term price declines will create more attractive buying opportunities. If you're a stockpicker, the rally hasn't buried all opportunity. Far from it! I recommend heavily favoring "quality" in your search, and avoiding the more speculative names that are highly exposed in this environment.

Morgan Housel has identified three high-quality companies that are still cheap.

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Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Coca-Cola, Microsoft, and Pfizer are Motley Fool Inside Value picks. Johnson & Johnson and Coca-Cola are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy wishes it had a graphing calculator.

Read/Post Comments (4) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 06, 2009, at 1:19 AM, dgmennie wrote:

    "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."

    It is statements like this this investors must take with a grain of salt. The "market" has yet to get back to the DOW pre-crash levels of 12,000+ so any "best quarter" at lower levels is still only dithering around, knee-jerk reactions to news soundbites and daily rumors. Good grist for speculators, day traders, and gamblers perhaps. But not something to bet your retirement money on.

    Only when the true unemployment numbers drop back to 3-4 precent and the US economy is robust once again will there be any "investment quality" to look for in the stock market.

  • Report this Comment On October 06, 2009, at 2:50 AM, joandrose wrote:

    Analysis paralysis again !

    What are we missing? The Dow would still have to rise by over 30% to get back to the level it was two years ago . Two years of inflation / erosion of wealth have also taken place since then .

    If employment levels have declined by maximum say 6% - to 10% from 4% - then surely total universe of "potential" consumer spending can at most only have fallen by 6% . Other factors are now at play - fear of spending mainly - not the ability to spend . As such, the Dow still has the "inherent" ability to rise back to 12000+

    A 6% drop in consumer spending is recouped in company trading profit by "downsizing" overheads etc . That's the job of management . As long as companies can continue to operate profitably, the Dow has the potential to move back to where it was - and beyond .

    A year from now and the Dow will be far above present levels.

    Whether the dollar will still have it's same worth is an altogether different matter.

    So - the Dow could be back at 12000 - and real wealth - buying power - still well down !

  • Report this Comment On October 18, 2009, at 12:22 AM, henryking54 wrote:

    <<If the S&P 500 went from being 15% overvalued to 20% undervalued -- for the statistics wonks, that's less than a one standard deviation move -- that would equate to a 30% loss, putting the S&P 500 at 737. I'd estimate the odds of a decline of that magnitude or greater over the next 12 months are better than 1 in 5.>>

    Mr. Dumortier doesn't understand statistics. His conclusion is completely wrong. You can't assess the probability of a percentage move in an index by calculating the standard deviation of an index's PE levels! Rather, you need to calculate the standard deviation of an index's annual change in PE ratio. It's obvious the simplistic calculation that Dumortier made: he took Shiller's data in Excel and calculated the standard deviation PE levels, which is 6.6. He then concludes that since the range between a 15% overvalued PE ratio (18.8) and a 20% undervalued PE ratio (13.1) is only 5.7, which is less than the 6.6 standard deviation, that there is a greater than 20% chance that the PE ratio will revert to 13.3 within 12 months time.

    Hogwash. If you calculate the standard deviation of annual PE ratio changes, you would discover that it equals only 4.24%, which at the current 18.8 PE ratio level, amounts to a decline only to an 18.0 PE level within 12 months. (0.9576*18.8).

    The Motley Fool should be much more careful which writers they let discuss statistics. Mr. Dumortier has proven incompetent on this subject and is misleading readers with faulty math.

  • Report this Comment On October 18, 2009, at 1:27 AM, daveandrae wrote:

    I've been investing long enough to see a single stock triple in value from the march 2000 highs, thus this entire essay is a joke. Those of us that know what we are doing are NOT investing in the "stock market." We are putting our hard earned dollars to work into real BUSINESSES, and if an entire business is worth buying, then one should be buying as many shares as he can afford. It should not matter where interest rates are, that it is October, Tuesday, or that the year is 2009.

    One should never, ever, be interested in what the stock market "thinks". The only thing a truly LONG TERM investor should be interested in, is the price the market is quoting him. Johnson and Johnson is cheap. GE is cheap. Apple is expensive.

    I do not know what the stock market is going to do next week, next month, or next year. NOBODY does! The more you try to "forecast" with charts, p/e ratios and things like "fancy math", the more likely you are to speculate with your money.

    In July of 1929, the DJIA was grossly overvalued at 431. Today, it sits at 10,000. Thus it is obvious to me that the stock market is not about "timing". The market is about time IN. I have 7 times more money invested in the stock market today, then I did when I started in 1998. In 1998 the s&p 500 was trading at 1175!

    Why people put so much energy into things they have absolutely NO control over, makes no sense to me.

    Buy equities. HOLD equities.

    Everything else is commentary.

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