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It's the beginning of the year, the time when analysts publish forecasts for the year ahead.
Of course, many of these forward-looking forecasts are based on data from the past. For example, one way to project a future price target for the S&P 500 uses the long-term average price-to-earnings (P/E) ratio and estimated earnings per share (EPS) for the next 12 months.
The long-term average is also used to determine if the stock market is overvalued or undervalued. When the current P/E ratio is well above the long-term average, the market is considered overvalued.
This is a simple, but widely used, approach to market forecasting. It's gained a great deal of popularity in recent years with the CAPE ratio, developed by Nobel Prize-winning economist Robert Shiller.
Shiller popularized the CAPE (which stands for stands for "cyclically adjusted P/E") ratio in the late 1990s when he warned investors of a potential stock market crash. According to Shiller, when the current CAPE ratio is well above its long-term average, the market is considered overvalued.
Shiller has collected data back to 1871 and found that the average CAPE ratio is 16.81. The current ratio -- which averages inflation-adjusted earnings over a 10-year period to adjust for the business cycle -- now stands at about 32, spurring concerns that the market is overvalued.
I have long been puzzled by this technique. CAPE has indicated the stock market has been overvalued almost continuously since about 1990... despite the fact that we've experienced two bear markets since then.
But the indicator seems to work differently before 1990. I believe that's because the world's central banks changed their policy around that time, as inflation targeting was becoming popular. (Inflation targeting is now used by all the world's major central banks.)
Prior to 1990, central banks fought inflation. Now, they want inflation to average about 2% a year. That seems to have affected the stock market, and I see that change in the CAPE ratio.
If we look at CAPE post-1990, we find it has averaged about 26. The current ratio of 32 is about one standard deviation above average. That's high but not overly worrisome.
Now, let's turn to a forecast for this year. First, we need an estimate of EPS. Then, we will apply the knowledge we have about the CAPE ratio to find a suitable P/E ratio.
The Case For Upside In 2018
EPS are in a state of flux. No one knows what the full impacts of tax reform will be yet, but analysts are expecting to increase EPS estimates.
A friend of mine works as an analyst at a major financial planning firm, and thousands of brokers around the country use his work. He told me he's increasing his estimate for S&P 500 EPS by $5 for this year.
Well, right now, he just has no idea what his actual estimate should be, so he is using $5 as a placeholder.
Most estimates are now around $140. Using $145 seems reasonable. Using Shiller's data, the average P/E ratio since 1990 has been 24.7.
Right now, the market is about average. Shiller's most current data shows a P/E ratio of 23.4. So, there is certainly room for upside in 2018.
With EPS of $145 and a P/E ratio of 24.7, my year-end price target for the S&P 500 is 3,580. That's more than 30% above current prices.
Now, I am not saying we will see a straight line up from here. There will be certainly be pullbacks along the way, but I expect large gains this year.
How To Trade The Upside
Now, if your takeaway from all this is that there's more upside to be had in 2018, then that's one thing. I think it's valuable looking at metrics like this and factoring it into your overall trading strategy.
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