With the bull market being in its fifth year, the overall stock market is becoming expensive according to historic market valuations. The markets tend to follow cycles, and a bull market cannot go on forever without any setbacks. Jeremy Grantham (Trades, Portfolio) of GMO LLC, with an educated guess, thinks that the market will likely be positive over the next couple of years and have a large correction. Grantham states that it could drop by half using standard deviations and mean reversion. According to his latest newsletter, here are Grantham’s best guesses as to what will happen over the next two years:
“Best Guesses for the Next Two Years
With the repeated caveat that prudent investors should invest exclusively or nearly exclusively on a multi-year value forecast, my guesses are:
1) That this year should continue to be difficult with the February 1 to October 1 period being just as likely to be down as up, perhaps a little more so.
2) But after October 1, the market is likely to be strong, especially through April and by then or in the following 18 months up to the next election (or, horrible possibility, even longer) will have rallied past 2,250, perhaps by a decent margin.
3) And then around the election or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”
His full newsletter can be read here: GMO Quarterly Letter: First Quarter 2014
There four are main indicators that I am watching to get an idea of where the markets are heading: the Shiller P/E, Total Market Cap over GDP, Chicago Fed National Financial Conditions Leverage Subindex, and Chemical Activity Barometer (CAB). These indicators support the general direction of Jeremy Grantham (Trades, Portfolio)’s market call. The indicators can be plotted on a chart through the following link: Economic Indicators.
The current implied future annual return of the Shiller P/E is 1.1 percent. The low reading is implying that the S&P 500 will have an annual return of only 1.1 percent including dividends over the next decade. The implied return is calculated with the idea that the Shiller P/E will revert back to its mean over time. Currently the Shiller P/E is 25.3, and the mean is 16.5.
The Shiller P/E was developed by Nobel Prize winner Professor Robert Shiller of Yale University. The Shiller P/E is a more reasonable market valuation than the P/E ratio because it eliminates fluctuation of the ratio caused by the variation of profits margins during business cycles.
The indicator is currently implying a 1.7 percent annual gain, including dividends, for the next eight years. Eight years is used because it is about the length of a full business cycle. The Total Market Index is at $19,996.4 billion, which is about 116.6 percent of the last reported GDP. As pointed out by Warren Buffett (Trades, Portfolio), the percentage of total market cap (TMC) relative to the U.S. GNP is “probably the best single measure of where valuations stand at any given moment.” Although GNP is different than GDP, the two numbers have always been within 1 percent of each other.
The index indicates the ease of lending In the U.S. Positive values indicate financial conditions that are tighter than on average, while negative values indicate financial conditions that are looser on average. The current reading is -0.6, indicating easy money conditions. The reading has remained at that level since November of 2013, even after the Fed announced their bond tapering program in December. The chart of the index shows that financial conditions tend to tighten before market downturns and recessions.
The CAB is the latest edition to the available economic indicators available at GuruFocus. It is a leading macroeconomic indicator that will highlight the peaks and troughs in the overall U.S. economy and illuminate potential trends in market sectors outside of chemistry.
The composite index compromises indicators drawn from a range of chemicals and sectors, including chlorine and other alkalies, pigments, plastic resins and other selected basic industrial chemicals. The indicator currently shows that the economy is getting stronger. Here is a statement released by the American Chemistry Council on April 22:
“After an economic deep freeze over the past several months, it looks like the U.S. economy is finally starting to bloom,” said Dr. Kevin Swift, chief economist at ACC. “Economists around the country are coalescing around the idea that the fundamentals of our economy may be healthier than previously believed. This is something that the Chemical Activity Barometer has been suggesting for quite some time,” Swift added.
The next CAB release is currently planned for May 27.
The Shiller P/E and the Total Market Cap over GDP are both indicating both indicating market returns of 1 percent to 2 percent over the next decade. Although this is not a certainty, overall market valuations tend to revert back to their mean.
In the shorter term, the Chicago Fed National Financial Conditions Leverage Subindex and the Chemical Activity Barometer are both indicating that this bull market has some more room to run. The indicators seem to be lining up in ways that support Jeremy Grantham (Trades, Portfolio)’s idea of the market going higher for the next couple of years and ending in a large pullback. Grantham relates the timing of the pullback to the presidential cycle and the magnitude to the reversion to its mean valuation in his newsletter.
The possible pullback in the market also lines up with the current Fed Policy. Interest rates are expected to increase by the end of next year, but they are expected to increase at a very slow rate. The leverage subindex will be an indicator to watch for how fast monetary policy is tightening. The CAB can be used as a leading indicator to see if the economy is beginning to slow down. At this time it is still showing a strengthening economy. It would be a very lucky guess if the markets play out as described above. Although the future is not known, we can use the information presently available to get a general idea of what is probable.