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Four Takes on the S&P's Return Prospects

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. It's been about a year since the market bottomed in March 2009, and over the trailing 12 months the market is up 40%. A lot of managers are telling us they're seeing fewer opportunities.

Morningstar's Ryan Leggio covers several notable managers that have great long-term track records. He also covers a lot of S&P 500 funds, and he's been asking around, "Is the S&P overvalued" or "Where is its value right now?" Thanks for joining me, Ryan.

Ryan Leggio: Sure.

Stipp: You have a range of opinions from some notable managers about how the S&P 500 is looking, how it's valued. Some of the managers that you look at, are they bottom-up managers? How are they valuing the market based on the S&P?

Leggio: They are bottom-up managers, and the common theme for most of them is they believe in this reversion to mean. So if the median P/E for the market over the last 50 years is 15, and we're at 17, they just track it down so what will the valuation be if it got back down to median levels.

Stipp: Sure. I think a lot of folks probably expect that obviously the market is not as attractive as it was a year ago when things were so depressed. But how pessimistic are some of these managers? Let's start with maybe the most pessimistic. Who is that, and what does he think?

Leggio: Sure. The most pessimistic of the kind of managers that we've been polling is GMO, and the big spokesperson there is, of course, Jeremy Grantham. They primarily run institutional money, but they also run some retail mutual funds through sub-advisory relationships through Evergreen.

Right now, they're projecting about 3% returns over the next seven years. That doesn't sound great, and they've been termed "perma-bears" and written off by a lot of people.

But if you look at their long-term track record, they're actually pretty good at measuring market valuations. At the beginning of the last decade, they forecast the S&P 500 would do -1.9% annualized. It actually did worse. It did -3.5% annualized.

The second thing I'd point to is back in March 2009, they were actually projecting great returns for the S&P, about 9%-10% annualized over the next seven years. So they're not always pessimistic, but now with the big market run-up, they're definitely more pessimistic about the S&P 500.

Stipp: We just happened to get a lot of that gain in a very short amount of time.

Leggio: Absolutely.

Stipp: A second manager, John Hussman, someone who we run some of his commentaries on Morningstar. Where does he stand on the S&P?

Leggio: Sure. He's about in the middle. He developed a proprietary metric called the price-to-peak earnings multiple. He looks at the peak earnings however many years back, puts the price in the S&P, and then tries to figure out, again, going from a regular P multiple of what the market is back down to its median or historical average, what would the valuation be.

He recently put up the numbers, and for the next 10 years he's forecasting 5.7%. Again, he was forecasting well in excess of 10% at the March 2009 bottoms, and that number has come in considerably.

Stipp: So a little bit better than GMO, but still not exactly...

Leggio: ...not great.

Stipp: ...blowing the doors off. The third one is Shiller. Where does Shiller stand, and how is he looking at things?

Leggio: Sure. Again, he uses backward-looking measures, and he really created this measure off of Graham and Dodd's work, which looked at trailing 10-year price-to-earnings multiples.

We looked at the data back since the S&P started, back in 1957, and right now we're at 22 on the Shiller P/E. It was about 15 back in March 2009. Typically, whenever the Shiller P/E has been between 20 and 30, you get somewhere about a 6%-7% annualized return.

So more optimistic than Hussman, but again, nowhere near the 9%-10% returns that investors usually expect from equities in the long run.

Stipp: Sure. And Morningstar equity analysts also look at the market from the bottom up, and I think we cover most of the S&P 500. Where are we standing on valuations here, internally, at Morningstar?

Leggio: We do. As of mid-April, if you look at any of our ETFs that track the S&P 500, you'll see that the price-to-fair value for the S&P, not the full market or wide-moat stocks, but just for the S&P, is right around fair value, which means our equity analysts, who are doing more forward projections than all of these measures which really rely on backward numbers, are projecting somewhere better than 8, 9, 10% annualized over the next decade.

Stipp: So a little bit higher than the others. It seems like obviously then there is a bit of a range of opinion. Are there any areas where these groups agree? Is there any common ground, something that you can take away from this?

Leggio: There is. We tried to look for some common ground, especially compared to GMO, which is forecasting 3%, and Morningstar equity analysts, which are forecasting much higher.

The one common ground we did see were in three stocks that Morningstar equity analysts rate as 4 or 5 stars, GMO owns in their Quality mutual fund, and Hussman owns in his Strategic Growth Fund.

Those three are Johnson & Johnson, Pfizer, and ExxonMobil. They share something in common, which is they're all wide-moat stocks for us, they have decent dividend yields of over 2.5%, and they have reasonable price-to-earnings multiples.

So it's not strange that all three of those managers would like them from a bottom-up perspective.

Stipp: It's certainly nice to see that overlap, and it's certainly something that investors might want to take a look into.

Leggio: It's not great. It's not the dozen of names we saw overlap back in March, but it's still better than nothing.

Stipp: Ryan, thanks for the insights, and thanks for joining me today.

Leggio: Absolutely.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.