of bulls, bears, and expected return: s&p-500

From 1982 to 2000, the US markets witnessed the greatest bull market period. Prior to that there have been at least 3 secular bear markets: From 1910 to 1924, from 1929 to 1944, and then from 1965 to 1982, the stock markets were under immense pressure. After the 2008 crash the markets were lying low; but then, the bulls began thrusting from 2013, and we are now staring at an obvious conundrum: is this a secular bull, or just cyclical, where we will see it wag between bull and bear side?

The markets are usually priced, and the most common pricing tool is the PE multiple. While the PE is not the only one to be looked at, fundamentally, it also depends upon cash flows, growth, and risk in cash flows of the business. The higher the cash flows and growth, and the lower the risk, the higher the PE multiple accorded to the business.  

From 1910 to 1924, the S&P-500 (at 10) went nowhere despite running around and increasing earnings by 1.47% annually. Perhaps, it didn't even meet the expectations of Lewis Carroll's The Cheshire Cat, where when you even walk long enough, you are sure to get somewhere. In September 1929, it stood at 31.30, helped by the mood of the market at the time representing 20 times earnings. By March 1933, the index was reduced to 6.23. It did start moving up from 1935, but then by 1942, it was again in a slippery zone, at 7.84 in April. It started getting better from 1943 onwards. Yet, it was able to match the previous high only in September 1954, albeit with a much lower multiple of 12. In January 1965, the index was at 86.12 with the multiple marching higher close to 19. Then came December 1968 and January 1973, leading the index to 106.50 and 118.40 respectively, but maintaining the multiple. By January 1980, the undertone was so low that the market thought it was apt to accord the index a value (110.90) equivalent of 7 times earnings. Even in January 1985, the index value of 171.60 represented only 10 times earnings. One had to wait until August 1987 to see the S&P-500, 21 times earnings, at 329.40. In October and November of 1987, the index was lower by massive 12% each month. If there was a marching bull, its horns weren't that clearly visible at the time. January 1997 (766.22) was not too high at close to 20 times earnings. Nevertheless, January 1998 saw the index valued at 24 times, and January 1999 (1248.77) at 33 times. The index was at 1485.46 in August 2000. The dotcom bubble started fizzling out after March 2000, affecting Nasdaq more than S&P-500. The irony was that it was valued at 46 times earnings in January 2002 at 1140.21. Only by January 2007 (1424.16), the multiple of 17 appeared more reasonable. Then again, it had to witness one of the largest falls in history, dropping from 1216.95 in September 2008 to 968.80 in October 2008; a 20% slip. Earnings fell significantly in 2009 when the index value of 865.58 in January appeared too expensive at 71 times. It did seem like an aberration only in hindsight, because by January 2011, earnings picked up rather significantly, and the index was 1282.62 at only 16 times earnings. Such lower pricing continued until 2013. It took more than 12 years for the index to get back to its August 2000 value when it touched 1480.40 in January 2013. Since then, the bulls have held horns thrusting up into the air effectively. As of now, the S&P-500 is trading at 2357.49, priced at almost 25 times earnings. 

Of course, you can play with the PE multiple the way you want to. However, the key is to be internally consistent when dealing with it. If we use forward earnings, the multiple gets lower. But then again, we can also use 5-year forward earnings and bring the multiple much lower. What analysts don't get is that they are revising the denominator without checking on the numerator. You can also use an average (say, past 3-year) earnings. There are far too many options.

Are you the buyer at these levels? An important data is the trend for the long term inflation and interest rates. That will decide the opportunity costs available to the investors. If the 10-year treasury is yielding 2.34%, anything higher than that should be fine given the expectation that treasury rates don't change significantly over long term. This is something we cannot predict though. Therefore, it will be more sensible if we expect a reasonable premium on the treasury rates. We need it just for the additional risk borne; and we also need it so that we are able to increase our long term purchasing power.

The American companies have been distributing cash, in the form of both dividends and buybacks, larger than earnings. Effectively, this has had no room for retained earnings, the gap for reinvestment being filled by debt. Obviously, this cannot continue forever.

Instead of valuing the index, if we attempt to price it, we need the near-term growth rate for the earnings of $95.25. Let's project it to be 5%; we can even be brave enough to project this rate for the next 10 years. Then we need an exit multiple for the index. We can choose 10, 15, 20, or 25 depending upon the level of our optimism. Based on the current index value of 2357.49, the expected return would be as follows:

At an exit multiple of 20, the expected annual return would be 0.62% and 2.79% over 5-year and 10-year period respectively. We, obviously, do not want that. The return would be just over 5% for both periods at 25 times. At a more aggressive multiple of 30, we have 9% and 7% returns. At 35 times, it would be 12% and close to 9%. Over 5-year period, a multiple lower than 19, and over 10-year period, lower than 15 would yield a zero percent return. Remember the bears that we saw in the stock market history? It doesn't take long for the bears to appear. Who can rule out lower multiples? Yeah, including dividends and buybacks, may be one can have returns of 2-3%.

I am not sure whether I will be the buyer at this levels. Heck, where else can I invest, and how much? All-treasuries?