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73-Year Chart Comparing Estimated Shiller PE Returns to Actual Returns

April 04, 2013 | About:

In The Siren’s Song of the Unfinished Half-Cycle John Hussman has a great annotated chart comparing the ten-year returns estimated by the Shiller PE to the actual market returns that emerged over the following ten years from each estimate (from 1940 to present):


Hussman estimates the ten-year return using a simple formula:

Shorthand 10-year total return estimate = 1.06 * (15/ShillerPE)^(1/10) – 1 + dividend yield(decimal)

He justifies his inputs to the simple formula as follows:

Historically, nominal GDP growth, corporate revenues, and even cyclically-adjusted earnings (filtering out short-run variations in profit margins) have grown at about 6% annually over time. Excluding the bubble period since mid-1995, the average historical Shiller P/E has actually been less than 15. Therefore, it is simple to estimate the 10-year market return by combining three components: 6% growth in fundamentals, reversion in the Shiller P/E toward 15 over a 10-year period, and the current dividend yield. It’s not an ideal model of 10-year returns, but it’s as simple as one should get, and it still has a correlation of more than 80% with actual subsequent total returns for the S&P 500.
Here is Hussman’s application of the simple formula to several notable points on the chart and comparison to the subsequent returns:

For example, at the 1942 market low, the Shiller P/E was 7.5 and the dividend yield was 8.7%. The shorthand estimate of 10-year nominal returns works out to 1.06*(15/7.5)^(1/10)-1+.087 = 22% annually. In fact, the S&P 500 went on to achieve a total return over the following decade of about 23% annually.

Conversely, at the 1965 valuation peak that is typically used to mark the beginning of the 1965-1982 secular bear market, the Shiller P/E reached 24, with a dividend yield of 2.9%. The shorthand 10-year return estimate would be 1.06*(15/24)^(1/10)+.029 = 4%, which was followed by an actual 10-year total return on the S&P 500 of … 4%.

Let’s keep this up. At the 1982 secular bear low, the Shiller P/E was 6.5 and the dividend yield was 6.6%. The shorthand estimate of 10-year returns works out to 22%, which was followed by an actual 10-year total return on the S&P 500 of … 22%. Not every point works out so precisely, but hopefully the relationship between valuations and subsequent returns is clear.

Now take the 2000 secular bull market peak. The Shiller P/E reached a stunning 43, with a dividend yield of just 1.1%. The shorthand estimate of 10-year returns would have been -3% at the time, and anybody suggesting a negative return on stocks over the decade ahead would have been mercilessly ridiculed (ah, memories). But that’s exactly what investors experienced.

The problem today is that the recent half-cycle has taken valuations back to historically rich levels. Presently, the Shiller P/E is 22.7, with a dividend yield of 2.2%. Do the math. A plausible, and historically reliable estimate of 10-year nominal total returns here works out to only 1.06*(15/22.7)^(.10)-1+.022 = 3.9% annually, which is roughly the same estimate that we obtain from a much more robust set of fundamental measures and methods.

Simply put, secular bull markets begin at valuations that are associated with subsequent 10-year market returns near 20% annually. By contrast, secular bear markets begin at valuations like we observe at present. It may seem implausible that stocks could have gone this long with near-zero returns, and yet still be at valuations where other secular bear markets have started – but that is the unfortunate result of the extreme valuations that stocks achieved in 2000. It is lunacy to view those extreme valuations as some benchmark that should be recovered before investors need to worry.
The actual return deviates from the estimated return at several points, including the most recent ten-year period from 2002. Hussman comments:

Note that there are a few points where the estimate of prospective market returns would have differed from the actual market returns achieved by the S&P 500 over the following decade. These deviations happen to be very informative. When actual returns undershoot the estimate from a decade earlier, it is almost always because stocks have moved to significant undervaluation. When actual returns overshoot the estimate from a decade earlier, it is almost always because stocks have moved to significant overvaluation. Note the overshoot of actual market returns (versus expected) in the decade since 2002. The reason for this temporary overshoot is clear from the chart at the beginning of this weekly comment: the most recent 10-year period captures a trough-to-peak move: one full cycle plus an unfinished bull half-cycle.
While Hussman’s formula is exceedingly simple, with a correlation of more than 0.8 it’s also highly predictive. It’s currently estimating very attenuated returns, and investors should take note.

About the author:

Greenbackd is a former corporate advisory and securities lawyer working in value-oriented activist funds management.

Rating: 4.0/5 (16 votes)


Traderatwork - 4 years ago    Report SPAM
That's just crazy talk. Macro stuff always looks grand and dandy especially with some chart of 50 years to go with. Boiled it down, will you not buy Mcdonald in 2003 when MCD trading around 25? or Coca-Cola trading< 20 (split adjusted) in 2008/2009? or all those company that earnings went up more than 5X in 2000 to 2010??? When those company make money/sales or provide a service to their customers do they check the Shiller Index first?

John Hussman try to use all these "talk" to cover his incompetent. full stop. Check out his record on his own website.

Did Munger and Buffett ever talk about b s like this? (Value) Investing is Simple: Buying $1 for less than a $1 .

Beware, academic always try to substitute knowledge with high math.

Cornelius Chan
Cornelius Chan - 4 years ago    Report SPAM

You make some very good points. Guys who make money in stocks are more practical than theoretical. Although the theory is important, taking action on an investment plan is a more practical exercise... as all exercise is LOL! Which is why your buying the high quality stocks MCD and KO at lows, regardless of externals, is an unbeatable strategy.
AlbertaSunwapta - 4 years ago    Report SPAM
Yes, Buffett has talked BS like this. Read Warren E. Buffett's 1977 article on inflation and his 1999 or 2000 article on the market's prospective returns for the coming decade plus Buffett's tracking of market value via GNP.

Also read Benjamin Graham's discussions around central market value.

Both of these guys kept an eye on aggregate market values.

Arnold van den Berg has talked about market replacement value, another aggregate tool to give one a sense of place in space.

And don't forget that Buffett has bought silver in the past and tried to hedge currency risk. His current derivatives positions are bets on market values, with the kicker of cash up front to buy those great value investments in the interim.
Suresharora - 4 years ago    Report SPAM
Used to read his comments religiously and even invested money in his fund. The whole objective was to sacrifice some of the upside but buy good amount of protection in the down markets. The fund's performance through up and down cycles has been pathetic. His models have not worked!

I can buy the "reversion to mean" and one does have to keep any eye on the overall market valuation but any model that is based on 50 years of history is bound to fail in projecting the future since a lot has changed in how the economic cycles behave now.
Sersoylu - 4 years ago    Report SPAM
I don't believe economic cycles have changed. Perhaps market cycles are bit more on steroids nowadays, but the fundamental is the same. All the great value investors preach that it never changes. I believe exuberance and greed on the upside, excessive fear on the downside will always be there.

If you look at Buffett's comments, he also said he probably should have sold some of his equity stakes before the dot.com bubble burst, when he wrote the famous 1999 article. Buffett and Munger both also talked about bull and bear market cycles, effects of inflation and interest rates on equities, etc, based on historical examples. He who ignores history will learn not to do it one way or the other.

I think value investing is fundamentals based. If you find a great bargain on an individual basis, you can't overlook it just because the market may be expensive. On the other hand, if the market is very overvalued, you should set aside more cash and be prepared for opportunities. The odds are you won't find many bargains in such a market anyway. The reality is today's market has a much longer way to go down than up, in my view, looking at historical data. Of course, that doesn't mean it won't go up or down for many more years from here.

There's something to heed in Hussman's data. But you don't need to make it the centerpiece of your investment strategy.
Vgm - 4 years ago    Report SPAM
"Yes, Buffett has talked BS like this. Read Warren E. Buffett's 1977 article on inflation and his 1999 or 2000 article on the market's prospective returns for the coming decade plus Buffett's tracking of market value via GNP."

Alberta -- you miss a critical point in your own statement, namely that Buffett comments on the macro every decade or so, and Hussmann pontificates every week! We know from the facts that his "method" of using on-going analyses of the macro as a basis for an investing strategy has simply failed. Buffett, Munger and Howard Marks (and other credible value investors) will tell you point blank that it cannot be done. Hussman's record is damning evidence of it.

It was amusing to see Hussman regurgitate Buffett's 2001 GNP argument recently. No reference to Buffett, of course.
Cornelius Chan
Cornelius Chan - 4 years ago    Report SPAM
Alpha, bravo, charlie, delta.
Cornelius Chan
Cornelius Chan - 4 years ago    Report SPAM

I agree with the flavor of your comments. To add my own 2 cents, I am finding more and more that no matter the DJIA or S&P 500 level there are always opportunities to make money in stocks.


I can't figure out which irritates you more... Hussman's fund performance or his weekly commentaries ;-)
Vgm - 4 years ago    Report SPAM
CWR -- thanks for your concern ;-) but neither his commentaries nor his performance irritates me in the least. They remind me of Einstein's comment that 'Doing the same thing over and over again and expecting different results is lunacy'.

Many people in life are definitely not worth worrying about. Ditto investing. What I learn from Dr Hussman is a how-not-to lesson. To paraphrase Buffett 'Just tell me where I won't make any money and I'll never go there'.

Good luck.
AlbertaSunwapta - 4 years ago    Report SPAM
When the market hits extremes Buffett has a history of speaking up. It's the statesman in him. Similarly, around those times I found myself searching out confirmation for my own sense that some extreme had been reached. It's those times that I seek out players that seem to be able to identify extremes and guys like Hussman provide quantification and opinion that the street never provides.

Hussman also seems to have done well protecting his investors on the downside. He may, or may not, be doing the very same thing again today. Time will tell. I take his opinion with a grain of salt today because a flight from bonds, Europe and alternative investments can buoy up domestic equity markets in a flight to safety, no matter what the equity market fundamentals indicate. Still, there's the zero sum nature to those markets that any reallocation theorizing can't ignore. There's two sides to every trade...

Note that Buffett said in the early 1970s that; 'if he'd stayed in the market, he'd have ended up with mediocre returns' that's an incredibly telling remark. In 2008 Buffett held mostly cash personally ($600 million) while BRK continued plodding on holding marketable securities. That's the nature of being for BRK the corporation vs. the individual investor.
AlbertaSunwapta - 4 years ago    Report SPAM
VGM, C.W.R., this quote is probably more to you liking (see below). However, I'd say that since there are five drivers of earnings, future corp. taxes might need to be added.

"As value investors, do you ever use macroeconomics?

Yes, we review macroeconomic factors. However, we have come to the conclusion that there are only three primary drivers that affect stock performance. And although you won’t always be right, if you concentrate on these three things, your investment decisions, overall, will probably be very good. They are inflation, interest rates and the fundamentals of businesses."

Buynhold - 4 years ago    Report SPAM
Value investing and macro-valuation analysis do not have to be mutually exclusive. If 2008/2009 has a lesson, it is that valuations (and macro factors) do matter. How an investor incorporates the macro into their portfolio is a matter of individual preference - some ignore it, some change the quality of their holdings, some change their asset allocation, and some use hedging to varying degrees.

It's not like bottom-up investing has been given some kind of blanket immunity from market dislocations. After all, how many investors survived the great depression? How many value investors did well in the 1970's?

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