Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

The Stock Market Will Go Up By 58% Over The Next 10 Years

The most common way to determine if stock market returns are overpriced or cheap is to use P/E ratios. The two schools of thought include that of permabulls, who argue that the stock market is cheap because of both the trailing 12-month P/E ratio and 2011 earnings estimates; and Permabears, who argue that the stock market is expensive because of a high Shiller’s P/E Ratio. The Yale economics professor who developed this, Robert Shiller, thought that average real earnings during the past decade is a better indicator of long term earnings. He created the cyclically adjusted P/E ratio (CAPE) to predict long term returns in the stock market. The average historical Shiller P/E ratio is around 16, and right now it’s above 20. That means, according to permabears like David Rosenberg, the stock market is overvalued by at least 20% based on this metric.

Insider Monkey thinks long-term interest rates should also be considered. When combined with long term interest rates, cyclically adjusted price earnings ratio could yield better signals. When long-term interest rates are high, stock prices and Shiller’s CAPE could be low. For instance, in March, 1980 Shiller’s P/E ratio was only 8.1 and the S&P 500 index was at 104.70. Ten years later, the S&P 500 index was 338.46, a 3-fold increase. However, in March, 1980 the 10-year interest rate was 12.75% and $104.7 invested in this would have compounded to $347.63 by March 1990. Clearly the stocks were undervalued by 50% according to Shiller’s P/E in 1980, but they didn’t outperform the bonds by a huge margin over the next 10 years.

Today, 10 year bonds yield only 2.4% whereas the cyclically adjusted earnings yield is close to 5%. Historically, when the cyclically adjusted earnings yield is 2-3 percentage points above the 10-year treasury yields, the S&P 500 index returns 58% in real terms during the following 10-year period. When the earnings yield –which is the inverse of the P/E ratio – is above the long-term interest rates, companies can borrow at cheaper rates and invest it in themselves and increase profits. The real yield of 10-year bonds right now is below 1%, so these bonds will return about 10% in the next 10 years. If stocks behave the same way they did in the past, they’ll return 58%, and will beat bonds by nearly 50% over the next 10 years.

Loading Comments...