Today The Standard and Poor's 500 Index reached 2950. I Lowered My Equity Exposure From 30% To 25% Of My Financial Assets.

In my last post I expressed concern that President Trump, due to his overriding interest in being reelected, would urge reopening of the economy prematurely--before sufficient testing would allow the scientists to recommend loosening the restrictions that had closed down the economy.  Unfortunately, premature opening is happening.

As a result, a resurgence in infections and a reimposing of restrictions seem probable near term. And another wave of virus cases late in 2020 is expected by the scientists. I continue to expect a slow economic recovery--a prolonged "U," if you will.

 I do realize  that summer's heat may moderate the rise of cases resulting from prematurely reopening the economy  And there is talk that a vaccine may be available during 2020 for hospital workers and others most vulnerable to the virus, such as the elderly and infirm.

With the Standard and Poor's 500 Index ("the Index")  at 2950,  my calculation of the Index's future risk/reward favors taking some profits. Today I lowered my equity exposure to 25% from 30% of my financial assets. The proceeds of the sale again are placed in short-term U.S. government securities as I continue to consider long-duration government fixed income to be grossly overpriced for those investors with a ten-year horizon.

How I Calculate Index Fair Value

Those readers of my previous posts are well aware that I use Shiller's CAPE ratio to determine the extent that the Index is overvalued, at fair value, or undervalued.  Shiller's mean CAPE ratio is 17; my modified mean CAPE ratio is 20--the average ratio over the last 50 years rather than Shiller's last 138 years. Fair value to me is when mean reversion to a CAPE ratio of 20 occurs.

Shiller takes actual annual Index earnings for the last 10 years, adjusts for inflation using the consumer price index ("CPI"), totals the ten results, and divides by 10.  I consider this to be "trend line earnings."

Shiller's CAPE ratio is available intra-day free of charge. If one divides the Shiller CAPE ratio into the Index price, you arrive at Shiller's earnings. Right now they are  roughly 107. During the Great Recession actual earnings declined 56%.  Last year's actual earnings were 157;  so,  if the  actual earnings decline during this recession equaled  that of the Great Recession, the low in annual  actual earnings would be 69.  The 2010 Index earnings adjusted for inflation are much higher than 69.  According to the way Shiller's model works, those 2010 adjusted earnings will be dropped and the 2020  earnings added. Furthermore, this year I expect the CPI to be negative--deflation rather than inflation.  So at the end of 2020,  Shiller's earnings may fall from 107 to roughly 100.  Fair value at the end of 2020 would then be 20 times 100, or an Index at 2000. From 2950, mean reversion then would imply a depreciation of 32%.

How I Calculate Future Returns

To calculate the Index's nominal compound annual total return for the next ten years, I assume that mean reversion to my adjusted CAPE ratio of 20 occurs at the end of the tenth year.  For example, assume the current CAPE earnings of 107.  I compound 107 at a 5.8% annual earnings increase to arrive at earnings in a decade of 188.  Multiply that by 20 to arrive at an Index fair price of 3760 in 2030.  From 2950, that would be a compound annual appreciation of 2.5%.  Add two percentage points for dividends to reach a compound annual total  return of 4.5%. At fair value the compound annual total return would be 5.8% annual appreciation plus the two percentage points for dividends, or 7.8%.