With the bull market roaring at the end of last year, Wall Street market strategists and pundits, almost without exception, were predicting double-digit gains for 2015. When the S&P 500 closed 2015 with a loss of nearly 1%, the double-digit number that stuck with investors was the gap between the rosy forecasts and the unhappy outcome.
Neither the prognosticators, nor the 401(k) crowd, should have been surprised by the market’s lackluster performance. In fact, given where stocks started the 2015, puny gains were about the best investors could hope for, and the danger of an actual decline loomed far higher than in most years. What's worse, the story is the same for 2016.
The reason is basic: When trading opened for 2015, stock prices were already exceedingly rich. Wall Street’s argument was the opposite. The strategists argued that valuations, measured by Price-to-Earnings ratios, were around normal, and that earnings would keep growing at rapid rates. In their view, a combination of stable multiples and rising profits would drive the S&P to big gains, extending the trend of the past few years.
They were wrong on both counts, and their misjudgment was obvious even then. P/Es only looked reasonable because of an explosion in profits that couldn’t be sustained, and wasn’t. The best measure of the whether stocks are cheap or expensive isn’t the current P/E, but the Cyclically-Adjusted Price-to-Earnings ratio developed by Yale economist Robert Shiller. The CAPE smoothes the peaks and valleys in earnings by using a ten-year average of S&P profits. At the end of 2014, the CAPE stood at 26.5. That’s more than 7 points, or around 40% over its average of 19 over the past 35 years, and 65% over its century-and-a-half norm of 16.
The CAPE was blinking red because prices were extremely high relative to any normal earnings number. The implication was that profits were already so much higher than normal that they were highly unlikely to continue the upward trend Wall Street predicted. The stats confirmed the skeptical view. Profits stood at historic highs by almost every measure, including return on sales, return on equity, and as a share of GDP.
As the CAPE suggested, the earnings boom fizzled. At the end of 2014, S&P earnings per share were $102.4. By the third quarter of 2015, they’d fallen to $92.88. Keep in mind that from 2003 to 2013, profits rose a remarkable 63%.
So where do we stand today? The basically flat market of 2015 did little to make stocks a bargain. The CAPE now sits at a still-lofty 26. Looking forward, the most likely return is the inverse, or “earnings yield,” of the CAPE, or around 4%, plus inflation of 1.5% to 2%, for a total of 5.5% to 6%.
That isn’t terrible, but it’s far below what the “experts” are predicting. And we’ll only get that 6% or so if that’s what investors are truly satisfied with. If they want more, stocks will have to decline sharply to raise dividend yields and allow investors to buy in at truly attractive prices. If they’re patient and resigned, we can expect modest gains. No one knows how it will turn out. But neither alternative is anything the folks selling stock want you to believe.