Shaun Rowles

Andrew Mitchell
November 1, 2020

EXTREME VALUATIONS AND FUTURE

RETURNS OF THE S&P 500

ABSTRACT

Higher than average Price-to-Earnings (P/E) ratios and Cyclically-Adjusted Price-to-Earnings (CAPE)
ratios have been tolerated by investors recently on the basis of low interest and inflation rates. This white
paper analyzes what level of returns can reasonably be expected going forward from today’s elevated
valuation multiples.

PREMISE
The Price-to-Earnings ratio is arguably the most widely used valuation metric. However, it offers only
measures the price of the S&P 500 in relation to one year of its earnings. Robert Shiller made the
significant contributions towards solving a myopic view of valuation by introducing the Cyclically Adjusted
Price to Earnings (CAPE) ratio, which utilizes the prior 10 years of earnings to smooth out spikes in the
business cycle.

In 2020, both valuation metrics reached levels that are in the upper extreme of their historical
distributions.

Building on prior work of Rowles & Mitchell, in which traditional valuation metrics were adjusted to reflect
the macroeconomic environment within which the readings are assessed, this paper sets out to identify
what return expectations investors can reasonably have based on current valuations.

To perform the analysis, data spanning 140 years was utilized to establish long run trends and provide a
sample size robust enough for informative signals.

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

Utilizing Robert Shiller’s data going back to January 1871, the P/E ratio reads 32.2 as of June 2020. That
reading falls in the extreme 98.1 percentile, lower than only 33 of the 1,796 monthly data points available.

140

0
120

27
100
80
120

120

120

120

120

120

120

120

120

120

120

120
114
60

93
40
20
0

Months with Lower P/E Months with Higher P/E

Every one of these outliers has occurred since January 1999 with the majority falling between June 2001-
December 2002 during the Dotcom crash or November 2008-January 2009 following the housing bust.

As we know, those periods of astronomical P/Es in the 98.2 to 100th percentile of the distribution were
actually very attractive entry points given that they followed major crashes. Therefore, it is prudent to put
more trust in the CAPE to smooth out those misleading spikes.

140
0

120
4

26

29
33

100
80
120

120

120

120

120

120

120

120

120

120
116

60
94

91
87

40
20
0

Months with Lower CAPE Months with Higher CAPE

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020
The current CAPE of 28.8 falls in the 94.3 percentile of the distribution since 1881. Of the 94 months with
a higher cape, all of them fall within the following three time periods:

- July 1929-October 1929

- February 1997-April 2002
- March 2017-February 2020

Said another way, the only precedent for CAPE levels as high as we see today are the periods leading up
to the Great Depression and the Dotcom Bust. Both of these time periods were historically poor entry
points to deploy capital.

Despite that both the P/E ratio and CAPE ratio are tipping the scales of the data since 1871, investors
remain willing to pay higher valuations for stocks during times of low interest rates and low inflation. In a
prior paper titled Inflation Targeted P/E ( https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3721008
), analysis was given on how to appropriately gauge market valuations within the context of the interest
and inflation rate environment. The results of that work demonstrated that despite extreme low interest
rates and in light of weak inflation rates, market valuations as of October 2020 were still elevated relative
to the historical context.

Given that both the P/E and CAPE valuation metrics are near all-time highs at the time of this writing, the
question becomes: what range of future returns can investors expect over the next 1-year, 3-year,
5-year, and 10-year periods? This paper defines a methodology and ongoing tool to forecast forward
expected returns within the context of changing macroeconomic conditions.

METHOD
The data set utilized for this analysis was Yale University’s Robert Shiller’s S&P 500 data spanning from
1871 to June 2020.

To calculate future returns, we ran linear regression analysis on the following variables: P/E ratio, CAPE
ratio, S&P 500 dividend yield, CPI inflation rate, 10-year U.S. Treasury bond yields, historical 1-year
returns, historical 3-year returns, historical 5-year returns, and historical 10-year returns. Finally, we
added variables for the percentile that many of the above variables fall within their historical distribution.

We ran a separate linear regression to predict each of the following dependent variables: 1-year future
annualized returns, 3-year future annualized returns, 5-year future annualized returns, and 10-year future
annualized returns.

After computing these forecasted future returns, we then ran a separate linear regression to predict the
current price of the S&P 500 to be compared to the current level of the index.

For that regression, we utilized the following independent variables: 10-year treasury yield, annual
inflation rate, dividend yield, prior 1-year returns, prior 3-year returns, prior 5-year returns, and prior 10-
year returns. Then, we added variables for the predicted future 3-year, 5-year, and 10-year returns that
were generated from the aforementioned regression analysis.

In this way, this last regression utilizes a layered “regression upon a regression” approach to compute a
unique algorithm for predicting the price of the S&P 500 index.

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

RESULTS: 1-YEAR FUTURE ANNUALIZED RETURNS

The linear regression output to predict future 1-year annualized returns is pasted below:

With a R-square of only .27, we can deduce that the algorithm does not effectively predict future 1-year
annual returns. It is worth showing these results as reinforcement to the commonly shared dogma that
short-term returns are highly volatile and difficult (if not impossible) to predict – even using a valuable set
of drivers like those in our data set.

With that said, it is somewhat informative to view the approximate expectations in context to the more
reliable longer-term predicted returns. At a minimum, showcasing the comparative 1, 3, 5 & 10 year
expected returns, with reliability increasing with time duration, illustrates the potential dynamics in return
expectations. We find this information more constructive than the widely used simple long-term average
guidance that the S&P 500 increases on an annual basis approximately 70% of the time with average
annual returns of 8-12%.

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

RESULTS: 3-YEAR FUTURE ANNUALIZED RETURNS

The linear regression output to predict future 3-year annualized returns is pasted below:

The regression output displays a higher R-square of .41, demonstrating that 3-year forward returns are
more predictable than 1-year forward returns. That said, even over a 3-year period, the predicted values
are not, in of themselves, overly reliable.

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

RESULTS: 5-YEAR FUTURE ANNUALIZED RETURNS

The linear regression output to predict future 5-year annualized returns is pasted below:

5-year returns are a bit more predictable than the 3-year returns with a smaller standard error. The
regression graphs below show a tighter fit with actuals, but with some significant deviations over 1,500
monthly data points.

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

RESULTS: 10-YEAR FUTURE ANNUALIZED RETURNS

The linear regression output to predict future 10-year annualized returns is pasted below:

The algorithm for 10-year forward returns is the most reliable among the four time periods we tested. The
R-square rises to .60 with the smallest standard error of .03. Additionally, the graphical output of our
predicted returns as compared to actuals demonstrates a fairly tight fit.

This clearly demonstrates that the predictive power of our variables are the highest over longer periods of
time, despite the counter-intuitive inclination to believe that it would be easier to predict returns over the
short-run. Put simply, valuations matter over the long-run. At today’s excessive valuations, our
algorithms are predicting much smaller returns from 2020-2030 than has been experienced in recent
memory.

We believe this information is exceptionally important for investors seeking to approximate financial
implications going forward rather than looking backwards. The vast majority of financial planning software
available to and in use by the average or retail investor captures past asset class performance and
projects it forward in estimations for the future. We believe that this can offer expectations that differ
significantly from future actual performance. Such errors of estimation can have very significant impact to
investors relying on a narrow range of potential outcomes.

In other words, any improvements that can be made to future return expectations could carry significant
benefits to probabilities of success for the end user. Simple straight-line calculations derived from
average historical behavior can be misleading, as an ever-changing macroeconomic environment can
present substantially different conditions within which assets are to perform. We believe a
macroeconomic-environmental-model to be more informative of future return expectations, especially
when those expectations are more likely to be too conservative versus too aggressive.

10

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

11

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

RESULTS: PRICE OF THE S&P 500

“

The linear regression output to predict the CAPE to deduce a forecasted S&P 500 price is pasted below:

The analysis to predict the price of the S&P 500 was our most successful regression test by far.
Producing a sky-high R-square of .93 and a very tight variance to actuals, our algorithms have proven to
be extremely accurate in predicting the current price of the S&P 500 index using these variables.

It is worth noting that the S&P 500 dipped below our predicted value during the March 2020 crash, but
then recovered to an elevated status in its v-shaped recovery. If our algorithms continue to be as
accurate as they have been, we expect the actual level of the S&P 500 to eventually revert back to our
predicted trend line.

While our other regressions illustrated that returns are tougher to predict, the price of the index is a much
different story. By identifying situations where the index is over-valued or under-valued relative to its
predicted level, wealth managers can use this information to make strategic investment allocation
decisions.

The intended use of this model is to augment current bottoms-up price estimates for the S&P 500 built
from the earnings-per-share estimates for the index constituent stocks. Improved insight is derived from
utilization of multiple models in concert rather than one model replacing others. This model captures
macroeconomic forces and operational environment effects that can sometimes be overlooked in
traditional EPS estimation models.

12

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

13

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

INTERPRETATIONS
In comparing the fit of the regressions over the different time periods, our analysis proves that longer-term
outcomes are much more predictable than short-term outcomes.

This may seem somewhat counter-intuitive since it may be harder to imagine what things may be like
over the next 10 years compared to just predicting the upcoming year. However, macro-level forces at
work eventually generate much more predictable long-term outcomes. On the other hand, there is likely
to be much more volatility in short-term returns that is exceedingly more difficult to predict.

Take for instance the following R-squared values for the four linear regressions run to predict future
returns:

1-year future annualized returns: .26

3-year future annualized returns: .40
5-year future annualized returns: .40
10-year future annualized returns: .60

The second major conclusion is that returns are expected to decline as we move through the 2020s. For
example, here are the predicted future returns going forward from June 2020:

1-year future annualized return (July 2020-June 2021): 13.6%

3-year future annualized return (July 2020-June 2023): 8.4%
5-year future annualized return (July 2020-June 2025): 7.1%
10-year future annualized return (July 2020-June 2021): 6.8%

For example, the lowest rolling 10-year return is expected to bottom at 4.5% annually for the period
starting in September 2018 and ending in September 2028. This decline can be attributed some
combination of either lower future returns or the inclusion of less favorable performance from historical
months within the rolling projections.

The last major conclusion is the S&P 500 price of the current period is highly predictable based on the set
of variables used, as illustrated by the impressive 93% R-squared. What made the regression so
accurate was not just utilizing typical variables, but also using both past returns and predicted future
returns as variables to predicting the current price. This produced an extremely tight fit.

Based on this second regression, the June 2020 S&P 500 valuation of 3,104 might be perceived as about
5.2% over-valued in comparison to our algorithm-generated estimate of 2,944. When applying the
anticipated 13.6% return from July 2020-June 2021, one may expect a price estimate of 3,466 at the mid-
point of next year assuming dividends remain constant.

Last, it is worth mentioning that there are always black swan events that can distort or disrupt these
estimates. That said, over longer periods of time, the existing macro forces tend to produce increasingly
predictable and reliable forecasts that investors can use in their investment decisions. As it stands, the
S&P 500 appears to be slightly over-valued (5.2%), and investors should expect future returns in the
2020s that degrade as we move through the decade ahead.

14

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

CONCLUSION
Since the creation of the first joint stock company, investors have been attempting to correctly value their
shares. Today’s environment is no different, and yet appears to be more confounding to a wide array of
experts than ever. We witness an almost daily argument about the valuation of the market with the most
revered names on Wall Street taking strikingly polarized positions. Is the market the most overheated
since the housing or dot-com bubble, or is it a relative value given the historically low interest and inflation
rates?

This paper assists investors in understanding future expected returns given the macroeconomic
environment. Within the context of extremely low interest rates and muted inflation readings, the
traditional market valuation metrics of price-to-earnings P/E and the cyclically adjusted price to earnings
CAPE ratios can maintain prolonged periods of elevated levels. When adjusted for the low rate and
inflation environment the metrics are still demonstrated extended valuations.

Investors deploying or maintaining capital at current inflation adjusted valuation levels can examine the
output within this paper to understand the likely future return expectations over the 1, 3, 5 & 10 year
periods. In addition, investors can utilize this framework to distill improved price level expectations for the
S&P 500 index relative to the prevailing interest rate and inflation environment.

15

Electronic copy available at: https://ssrn.com/abstract=3727447

 Shaun Rowles
Andrew Mitchell
November 1, 2020

SOURCES
Shiller, Robert. “U.S. Stock Markets 1871-Present and CAPE Ratio”. Yale University.
nd
Data from Irrational Exuberance [Princeton University Press 2000, Broadway Books 2001, 2 ed., 2005]

http://www.econ.yale.edu/~shiller/data.htm

16

Electronic copy available at: https://ssrn.com/abstract=3727447