Following the huge uptrend since last March, the outlook for the S&P 500 and other leading international stock indices appears to be clouded in uncertainty. A major short-term negative for the S&P 500 is that the recent strong rally has brought the index to an overbought level (as an example, its latest close was 15% higher than the 200-day moving average). The S&P 500 has never experienced such a sharp increase (+58%) in such a limited time period. However, even though we believe that an equity market correction is a near-term possibility, we would not lighten up positions or exit the equity market until a clear trend reversal takes place as we would not try to sell at the top of the market but to remain invested in the trend direction.
But institutional and long-term investors had better focus on the equity market medium/long-term prospects than on the S&P 500 short-term swings. Projecting the equity market performance for the 10 years ahead is key for determining how to allocate a portfolio between equity funds and bond funds. Although this is no easy task, we will try to predict the S&P 500 moves for the next 10 years using the John Bogle’s (founder of Vanguard Mutual Fund Group) model we find on the Mark Boucher’s book "The Hedge fund edge".
Under the model, we should take the dividend yield at the beginning of the projected decade to forecast stock and bond returns in the following 10 years, add the average annual earnings growth for the past 30 years and compute what rate of return would have to develop over the subsequent 10 years to achieve that average P/E at the end of the term and add this final number to the previous table. As we can see in the chart below this model has a good track record for projecting the S&P rate of return. We are looking for an average annual return of 8% for the S&P500 from now to 2019 with a range between 3.5% and 12.5%. Even though this rate of return is lower than past returns, we believe this is enough to recommend investors assigning a neutral weight to the equity market in their institutional portfolios. Indeed, with the 10-year US Government bond at 3% the S&P 500 is likely to post the extra-performance needed to invest in equities.