This suggests an economic recovery in late 2009 or early 2010 continuing with a less than normal recovery for several years. Also Inflation gradually rises.
Scenario 2: “Stagflation”
This also suggests an economic recovery in late 2009 or early 2010 and a less that normal recovery for several years. However it is followed by STRONG INFLATION in the 5-8% range near the end of the five year period.
Scenario 3: “Severe Recession Accompanied by Deflation”
This is a bitter scenario because it forecasts an extended and deep recession causing prices to spiral downward through 2010. The recession does end but the following economic growth is very anemic.
Scenario 4: “Goldilocks”
Everything is just right because the Government’s “kick-start” gets the economy growing in late 2009, followed by average growth with moderate inflation.
Since these are the four scenarios most likely to occur, the next question we need to ask is: What are the possible returns of the stock market under each scenario?
Before examining the chart, let’s get a little knowledge about a few of the numbers that appear in the first two rows.
First we want to add up all of the companies’ earnings that make up the S&P 500 and compare them to the price of the S&P. In 2008 the S&P’s earnings added up to about $501. As of this writing the index of the S&P stands at just under 900, therefore a simple math calculation puts the price as a multiple of earnings to (PE) around 17. Just to reiterate, this means the average company in the S&P 500 sells at 17 times its earnings.
Now this PE multiple thing is not a static number. A lot of things like interest rates and inflation among other things can affect it, but our research forecasts the following earnings and PE ratios under each of the four scenarios. The chart below organizes all of this and forecasts possible returns based on a given price level of the S&P 500.
Look at the left hand column under “Starting S&P 500″. Go down to the number of 900 which is where the S&P 500 is at the current time. Following across, one can see the possible returns under each scenario. Under the Muddle Through scenario, the possible future annual return of the S&P 500 over the next five years is 5.2%. Under the Stagflation scenario it’s 2.7% For Deflation it is between -3.5% and .5% and under Goldilocks; 13.9%. (Hurray for Goldilocks).
Realistically, we don’t know which scenario is going to work out so to be extra careful, we would want to buy the S&P 500 at a lower price just to build in a margin of safety.
Move up to 800 on the left hand column and the numbers start to look better, but not ideal.
During the latest sell-off which occurred in March of ’09, the S&P 500 dipped to 680. I don’t think we will see the 680 lows again but I do think 750 is a good possibility, so let’s look at that.
The possible future returns at 750 range from .05 to 18.5%. If we eliminate the extremes of deep painful recession and a goldilocks economy, we are left with returns in the 7% to 12% area. This is a decent return and one that will create real wealth for those with the patience and fortitude to stay invested. This return won’t come easy, however. Remember I’m forecasting an average annual return. The word average sounds safe, but it is one of the most dangerous words in the investment vocabulary.
“You know it don’t come easy…”
– George Harrison
For example, it can be said that if you have your head in the oven and your feet in the icebox, your average temperature could be 98.6o, but of course you will probably not be around to measure it.
The same is true for investing. To get an average rate of return of 10% you will probably have to experience annual volatility of 20% and maybe more. That means that the range of returns in any one year could swing by 40%. This is not for the faint of heart and as we saw last year, many were not able to stomach it and keep their faith about the future.
There we have it; an idea of possible future returns under four economic scenario at numerous price levels of the S&P 500. This is not crystal balling, nor is it wild guessing. In my opinion, since one of these four events will actually occur, we can choose our entry back into the market accordingly. We can control our investing destiny rather than having the market or our emotions control us.
This is the essence of successful investing and the essence of wealth creation.
Steve…
All investors are compelled to guess the future direction of the economy and the stock market. Whether by gut feeling or the use of sophisticated mathematical algorithms, the future is not predictable and any attempt to forecast it is a futile enterprise. Past performance will give us no more insight into the future than crystal balls or astrology. Warren Buffett quips that if past performance were all that was required to be successful, all of the rich people would be librarians. Furthermore, Wall Street types who forecast the market really have no more clue than you or me; however they compound their problem by giving pin-pointed forecasts which are wrong most of the time.
It is far better to approach this question by coming up with a list of reasonably valid scenarios that include the full range of economic outcomes and then try to attribute a rate of return for the market over the next 5 years. While not perfect, this can be done with some accuracy, due to the fact that we are forecasting a range of returns over a longer time horizon (5 years).
Scenario 1: “Muddle Through”
Scenario 2: “Stagflation”
This also suggests an economic recovery in late 2009 or early 2010 and a less that normal recovery for several years. However it is followed by STRONG INFLATION in the 5-8% range near the end of the five year period.
Scenario 3: “Severe Recession Accompanied by Deflation”
This is a bitter scenario because it forecasts an extended and deep recession causing prices to spiral downward through 2010. The recession does end but the following economic growth is very anemic.
Scenario 4: “Goldilocks”
Everything is just right because the Government’s “kick-start” gets the economy growing in late 2009, followed by average growth with moderate inflation.
Since these are the four scenarios most likely to occur, the next question we need to ask is: What are the possible returns of the stock market under each scenario?
Before examining the chart, let’s get a little knowledge about a few of the numbers that appear in the first two rows.
First we want to add up all of the companies’ earnings that make up the S&P 500 and compare them to the price of the S&P. In 2008 the S&P’s earnings added up to about $501. As of this writing the index of the S&P stands at just under 900, therefore a simple math calculation puts the price as a multiple of earnings to (PE) around 17. Just to reiterate, this means the average company in the S&P 500 sells at 17 times its earnings.
Now this PE multiple thing is not a static number. A lot of things like interest rates and inflation among other things can affect it, but our research forecasts the following earnings and PE ratios under each of the four scenarios. The chart below organizes all of this and forecasts possible returns based on a given price level of the S&P 500.
Realistically, we don’t know which scenario is going to work out so to be extra careful, we would want to buy the S&P 500 at a lower price just to build in a margin of safety.
Move up to 800 on the left hand column and the numbers start to look better, but not ideal.
During the latest sell-off which occurred in March of ’09, the S&P 500 dipped to 680. I don’t think we will see the 680 lows again but I do think 750 is a good possibility, so let’s look at that.
The possible future returns at 750 range from .05 to 18.5%. If we eliminate the extremes of deep painful recession and a goldilocks economy, we are left with returns in the 7% to 12% area. This is a decent return and one that will create real wealth for those with the patience and fortitude to stay invested. This return won’t come easy, however. Remember I’m forecasting an average annual return. The word average sounds safe, but it is one of the most dangerous words in the investment vocabulary.
The same is true for investing. To get an average rate of return of 10% you will probably have to experience annual volatility of 20% and maybe more. That means that the range of returns in any one year could swing by 40%. This is not for the faint of heart and as we saw last year, many were not able to stomach it and keep their faith about the future.
There we have it; an idea of possible future returns under four economic scenario at numerous price levels of the S&P 500. This is not crystal balling, nor is it wild guessing. In my opinion, since one of these four events will actually occur, we can choose our entry back into the market accordingly. We can control our investing destiny rather than having the market or our emotions control us.
This is the essence of successful investing and the essence of wealth creation.
Steve…
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