The Next Recession

When do you expect the next recession? Within 5 years? Within 10 years?

In either case, it is time to hold cash.

Today’s Market

Today’s S&P500 index level is close to 1350. P/E10=28.3. The S&P500’s most likely return over the next ten years is 0.84% (real, annualized, total return). Its likely range is from -2.2% to +3.8% (inner confidence limits). Its outer range is from -5.2% to +6.8% (outer confidence limits).

Money market fund interest rates have risen. They are delivering the 1%+ real returns of the past.

Recessions and Stock Prices

I have extracted the nominal and real S&P500 prices for January 1990 and January 1991 from Professor Robert Shiller’s database.

1990.01 339.97 506.2190659
1991.01 325.49 458.7329346

Converted into percentages, the prices fell to:

Nominal: 95.7%
Real: 90.6%

More recently, the nominal and real S&P500 prices for January 2000 and January 2003 from Professor Robert Shiller’s database:

2000.01 1425.59 1602.099662
2003.01 895.84 935.2825977

Converted into percentages, the prices fell to:

Nominal: 62.8%
Real: 58.4%

During the next recession, we can expect the (real price of the) S&P500 index to fall by 10% to 40% after adjusting for inflation.

Sharper Drops

The historical record suggests much sharper price drops within 10 to 15 years.

Adjustment to the Annualized Return

The annualized return formula is (1+annualized return)^(number of years) = (final balance/initial balance).

A (real) price drop of 30% within 5 years is equivalent an annualized (real) return reduction of 6.9% per year.

If spread over ten years, it is the equivalent of an annualized (real) return reduction of 3.5% per year.

These numbers are consistent with the ten year annualized return projections based on today’s P/E10.

Opportunities

The most probable returns from money market funds and the S&P500 index are almost identical. [Today, the money market is more attractive.]

The S&P500 index spreads the range of likely outcomes at Year 10. It is great for gamblers. It has an equal upside and a downside of 3% per year (inner confidence limits) to 6% per year (outer extremes). The odds of beating the money market are almost 50%-50%.

If we have a recession within the next 5 years, we may be able to buy stocks at 60% to 70% of pre-recession prices. Stated in terms of dividends, we will see yields increase by a (multiplicative) factor of 1.1 to 1.7. Instead of today’s 1.78% dividend yield, we can expect S&P500 dividends of 2.0% to 3.0%.

Sharper drops offer even better opportunities.

Have fun.

John Walter Russell
October 9, 2006
Revised wording: November 16, 2006
Corrected calculations: January 13, 2007