The S&P 500 Could Reach 2,800 in 2018
Asset classes are similar to “tectonic plates” in the sense their very slow shifts explain long term market price directions and reversals. Based on the EAST model described thoroughly in this article, the S&P 500 is now overvalued and it could become even more by potentially reaching 2,800 in 2018.
With stock markets making fresh new highs in Q1 2017, it is more time than ever to ask ourselves if this period of complacency is coming to an end. After all, we are in the late stage of a business cycle: PMIs are quite high, credit is tightening, the Fed is applying a restrictive monetary policy, etc.
The metrics used by investors to assess market conditions always been the same traditional ones available over the last decades: Trailing P/E, Forward P/E, Market Cap/GDP, CAPE, Tobin’s Q, Fed Model, etc. The problem with those is that they fail to explain stock market returns very well.
A novel metric to predict long term stock market returns is the Average Investor Equity Allocation from the Equity Asset Supply Theory (EAST), introduced by the unknown blogger behind Philosophical Economics. Per its author, the EAST holds on five hypothetical assumptions and one equation:
- Financial assets are classified into three main asset classes: 1) stocks, 2) bonds and 3) cash.
- Bonds and cash are roughly approximated by the Total Liabilities of Real Economic Borrowers.
- An investor must always hold a unit of a financial asset for every financial asset unit available.
- The supply of an asset is its total market value: number of units * market price of each unit.
- Any desired asset allocation can be made on financial markets following supply and demand.
Average Investor Equity Allocation = Equity Asset Supply which is estimated as:
Real economics borrowers are entities that can create net new financial assets. Those fit into five categories: 1) Non-Financial Corporations, 2) Households, 3) Fed Reserve, 4) Local & State Governments and 5) Foreigners. Financials are excluded because they only serve as intermediaries.
When Equity Asset Supply is scarce, investors are seeking to increase their average equity allocation which drives prices higher and sometimes trigger new equity issuance. Both effects drive the Equity Asset Supply until demand is exceeded and a reversal occurs just as shown on the chart above.
The relationship between the Equity Asset Supply Adv. 10Y and the Annualized 10Y S&P 500 Total Return is best shown with a scatter plot. The correlation is extremely high at nearly 0.90. We can calculate an Estimated 10Y S&P 500 Total Return regression of approximately Y = -0.70X + 34.
Now let’s think outside the box: If we calculate the differential between the actual and the estimated annualized 10Y S&P 500 Total Return, we get the chart below. The S&P 500 tends to overshoot or undershoot the regression at extremes. This becomes valuable information for an investor:
This is the first time the differential is “expensive” in nearly a decade! The last time this condition occurred was in Q3 2007, just before the bear market. Historically, the differential stayed “expensive” for two quarters before plummeting to the opposite extreme, which brings us at least to Q2 2017.
Now if we display the signals generated from the differential as a layer over the historical S&P 500 Total Return, we obtain the chart below. The EAS differential can identify most major market peaks and troughs accurately. Is there another way to estimate how long the S&P 500 can remain expensive?
Fortunately, we can convert the Estimated 10Y S&P 500 Total Return regression into future S&P 500 Total Return values. As shown on the chart below, the model does not predict the amplitude of corrections but plateau levels near bear markets, as in 2001, 2007 and perhaps soon in 2018.
Based on the forecasted equity curve, the S&P 500 could reach 2,800 by the end of 2018. Markets are expensive but they can become seemingly even more. Two things to keep in mind: 1) market tops are a process, not an event and 2) markets can stay irrational longer than we can stay solvent shorting it.
This S&P 500 2,800 forecast was already available in 2013 using this approach. Back then, the S&P 500 was trading only at 1,800, a far cry behind what seemed to be crazy target. With the S&P 500 at 2,400, this target becomes less of a wishful thinking but a remote possibility that can’t be ignored.
We won’t put all our eggs in one basket by relying solely on the Equity Asset Supply as it is only one of many tools we are monitoring on a regular basis. The goal of this article is to popularize the EAST and display two different ways its main metric can be used to assess stock market future returns.
