Riding The Bull
As we get into the final stages of the U.S. Federal Reserve raising the federal funds rate, it is natural to think more about a potential bull market rather than a bear market. While so far the low in the S&P 500 was last October, we still don’t have enough data to say that we have entered a new bull market – it will only be clear in hindsight. In the meantime we can compare the valuations of the S&P 500 at the start and end of previous bull markets to the October and current valuations. If October does turn out to have been the start of the next bull market, we can estimate whether the ride will be wild or tame.
Data and Definitions
Using the methodology from my 2020 blog History Is No Mystery: Part II, a bull market is defined as the period between the low of one bear market and the peak before the next bear market. For valuations, I used the cyclically adjusted price-to-earnings ratio methodology to be consistent with my previous blogs. A high CAPE means the market is expensive and future returns are expected to be smaller than average. A low CAPE means the market is cheap and future returns are expected to be larger than average.
Historical Bull Markets
Table 1 below shows all the bull markets since 1933. Columns 3 and 4 show the total increase in the price level of the S&P 500 and the length of the bull market in years. Column 5 is the annualized increase, column 6 shows the level of the CAPE at the low, and column 7 the level at the high. Column 8 shows the percentage increase in the CAPE for each bull market.
Table 1
Looking at the median bull market, the S&P 500 price level increased by 123% over 4.6 years, for an annualized increase of 20%. The median CAPE rose from 14 at the low to 22 at the high, a 45% increase.
Bull Price Increase vs CAPE
As expected, there is a positive relationship between the amount of the increase in the price level of the S&P 500 and the CAPE increase. Chart 1 shows the percentage price increase on the vertical axis vs the percentage CAPE increase on the horizontal axis. Generally, the larger the CAPE increase the larger the price gain. The green line shows the estimated increase in the price[1] given the actual percentage CAPE increase.
Chart 1
Will the Next Bull Be Wild or Tame?
If October was the S&P 500 bear market low, then let’s take a look at the return implications. The CAPE was 27 in October, higher than any of the lows of the previous bull markets. It is even higher that the median CAPE of 22 at the bull market highs. Since 1933, only 14% of monthly CAPEs were higher than 27. Given the level of the CAPE, unless we go back to near zero interest rates and quantitative easing by central banks, the CAPE is more likely to go down over time rather than up. This means the next bull market is likely to be tame.
How tame?
Research Affiliates estimates that the fair market value of the CAPE for U.S. large capitalization stocks is around 23. According to our simple regression using previous bull markets, that level would result in a S&P 500 price increase of 32% in the next bull market, or about 6% per year if the bull market lasted the median time of 4.6 years.
Portfolio Implications
Forecasting the market is extremely difficult, especially over the shorter term. I only used a simplistic process in this blog to highlight how the market is still on the richer side of fair value (the current CAPE is 29). This makes it more likely that the next bull market in the S&P 500 is likely to have below average returns. However not all stock markets are in the same situation, as seen in the Research Affiliates’ CAPE estimates. This bolsters the case for diversified exposure to non-U.S. stocks.
Invest Wisely,
Dave Schaffner, CFA
Principal, Wayfairer Capital Management Ltd.
[1] The estimate is from a regression of the percentage price increase on the percentage CAPE increase. Due to the small number of bull markets, there is high degree of estimation error.