After probably the worst start of any calendar yearai??i?? everai??i?? wouldnai??i??t it be nice to be able to make your OWN Stock Market Forecast for the remainder of 2016?
Think about it. The major stock market averages are on the cusp of their first real bear market since the financial crisis.
Indeed, the S&P 500 has been down as much as 11% so far this year, after suffering through repeated waves of selling during the first part of 2016. The Dow, meanwhile, has experienced the largest decline for this blue-chip index since 2011, as it has dipped below the key psychological support level of 16,000 several times during the first three weeks of 2016.
In fact, the five worst early Januaries for stocks (before this yearai??i??s debacle) took place in 2009 (the S&P 500 was down 6.6% in the first 10 trading days), 1978 (down 6%), 2008 (down 6%), 1935 (down 5.7%) and 1982 (down 5.1%).
Stocks are selling off around the world because of major volatility in China’s stock market. Thatai??i??s because, as we explained in a recent article, we are in slow-to-no-growth world with Chinaai??i??s economic woes.
Indeed, fears of a bigger-than-expected slowdown in the world’s second-biggest economy are on the rise, which is a negative for markets as China has been one of the world’s biggest drivers of growth in recent years. Fears range from China’s exporting recession to the rest of the world,Ai??causing another meltdown in the global financial markets.
There is also aAi??great concern that Chinese authorities are making the situation worse — and that theirAi??willingness to let its currency (the yuan) weaken, will signal an even weaker economic situation than the ChineseAi??government isAi??publically willing to admit.
This treacherous sledding on Wall Street has left many investors feeling shaken with many believing that there is more pain to come.
I frankly donai??i??t know and anyone that tells you that they do is either a fool or a fraud. However, as I recently wrote, I expect the markets to be volatile as the deflation-inflation tug-of-war continues to play out across the globe, making it difficult for stocks to make much headway from their beginning of year levels.
But instead of relying on me or any of the mainstream media pundits to tell you where the market is headed for 2016, I am going to show you how to make your own stock market forecast.
Thatai??i??s right, Iai??i??m going to explain how to use a simple, yet powerful, model to make your very own 2016 stock market forecast.
Recall that in previous articles Iai??i??ve introduced you to this 3-factor model for analyzing stock market returns. The three factors in the model are easy to identify and they are: beginning dividend yield, earnings growth, and change in the price-earnings ratio. When you add all three factors together, the result equal total stock market return.
OK, letai??i??s get started. The first step in forecasting this year’s stock market return is obtaining the dividend yield on the S&P 500 at the beginning of the year. This number is easy to find because itai??i??s readily available from a number of sources on the internet. At the beginning of 2015, it was 2.11%, according to www.multpl.com.
The next step is estimating the earnings growth for the S&P 500 in 2016. After doing some research, youai??i??ll find that Wall Street analystsai??i?? estimates range from a pessimistic -2% to an optimistic 10%. As you read on you’ll see a range — instead of an exact number — will work just fine for our forecast. Now comes the hard part: developing an estimate for the change in the stock marketai??i??s price-earnings ratio. But we have a solution for this issue.
Take a look at the chart below: This chart reports what is known as the ai???Shiller PE Ratioai??? from 1900 to its level at the beginning of 2016.
While there are several conventional methods to calculate price-earnings ratios (any of them will work in our 3-factor model),Ai??I prefer the Shiller method because it normalizes the price-earnings ratios over economic cycles.
You can also find an up-to-date chart of the Shiller PE ratio at http://www.multpl.com/shiller-peAi??for future use. As you can see, the Shiller PE ratio at the beginning of 2016 was 26.49ai??i?? which is well above the historical average of 16.7 and is approaching the level it attained just before the sub-prime bubble burst. But in the current low-interest-rate environment, many believe an elevated level can be justified.
Our task now becomes estimating the year-end Shiller PE level. This is a challenge but the way around this problem is to use a range — just as we did with the earnings growth component of the model. For our example, letai??i??s use a range of 16 on the low end (which is about the historical average) and 30 on the high end (which is above the level experienced before Black Tuesday and the Sub-Prime crisis but below the Internet Bubble peak).
Letai??i??s pause for a moment to summarize where we are: We are calculating a US stock market forecast for 2016 using a 3-factor model:
- with a beginning dividend yield of 2.11%
- 2016 earnings growth of -2 to 10% and
- An ending Shiller PE multiple of 16 to 30.
Now, letai??i??s sharpen our pencils and get started doing the arithmetic. Ha, just joking. To make this easier for you, Iai??i??ve done all the calculations and presented them in the table below. If you want to know how the calculations are made, you can email me at bill@bookwormsports and Iai??i??ll send you the excel spreadsheet.
So what does this allAi??mean?
First off, if you take a middle of the road approach and assume that earnings growth for the year comes in at around 6 %, and the market can hold onto its beginning of the year PE multiple of about 26 (it declined to about 23.5, according to www.multpl.com, during the recent China related sell-off), the table tells us that the market will post an 8.1 % return for the year. To find this number, simply look at the 6 % earnings growth column, and then follow down to the 26 in the year end Shiller PE ratio row.
If you are more of a pessimist and expect no earnings growth and the PE ratio to contract to 20 by the end of the year, then your forecast is for the market to plunge by 21%.
On the other hand, an optimistic view, would be to assume 8% earnings growth and a PE multiple expansion to 30, which would propel the US stock market to a positive 25.5 % return for 2016. As you can see for yourself, there are lots of other possible scenarios.
For me, I see a muddle-through environment where earnings rebound a bit, benefiting from 2015ai??i??s energy price collapseai??i??growing at around 6% for 2016. I expect the PE multiple to contract a little for a couple of reasons. Number 1, investors begin to accept the reality of a slow-to-no growth world. And Number 2, investors are beginning to understand the limitations of the worldai??i??s central banks in-fighting the forces of deflation ai??i?? closing the year at around 24. If these assumptions are correct, then the resulting return for the US stock market will be essentially flat in 2016.
So there you have it: You now have a model to make your own 2016 US stock market forecast so you can stay above the fray and ignore the day-to-day noise put forth by the mainstream investment media which is of little to no use for the thoughtful investor.
The bottom line for profitable investing in this environment ai??i?? as I noted in my last article ai??i?? is to use volatility as a tool to buy growth at the right price. After all, it was Warren Buffett who said: ai???Price is what you pay and value is what you get.ai???
Keep an eye out for a future article in which Iai??i??ll explain why PE multiples are so volatile in the short-run and how changes in investor emotions can cause them to change on a dime.
Until next time,
Bill is President and Senior Managing Director at Plimsoll Market Capital, a national wealth management firm that provides financial, tax, and investment advice to wealthy families.Ai??