All investors are compelled to guess the future direction of the economy and the stock market. Whether by gut feeling or the use of sophisticated mathematical algorithms, the future is not predictable and any attempt to forecast it is a futile enterprise. Past performance will give us no more insight into the future than crystal balls or astrology. Warren Buffett quips that if past performance were all that was required to be successful, all of the rich people would be librarians. Furthermore, Wall Street types who forecast the market really have no more clue than you or me; however they compound their problem by giving pin-pointed forecasts which are wrong most of the time.
The Four Most Likely Scenarios
It is far better to approach this question by coming up with a list of reasonably valid scenarios that include the full range of economic outcomes and then try to attribute a rate of return for the market over the next 5 years. While not perfect, this can be done with some accuracy, due to the fact that we are forecasting a range of returns over a longer time horizon (5 years).
Scenario 1: “Muddle Through”
This suggests an economic recovery in late 2009 or early 2010 continuing with a less than normal recovery for several years. Also Inflation gradually rises.
Scenario 2: “Stagflation”
This also suggests an economic recovery in late 2009 or early 2010 and a less that normal recovery for several years. However it is followed by STRONG INFLATION in the 5-8% range near the end of the five year period.
Scenario 3: “Severe Recession Accompanied by Deflation”
This is a bitter scenario because it forecasts an extended and deep recession causing prices to spiral downward through 2010. The recession does end but the following economic growth is very anemic.
Scenario 4: “Goldilocks”
Everything is just right because the Government’s “kick-start” gets the economy growing in late 2009, followed by average growth with moderate inflation.
Since these are the four scenarios most likely to occur, the next question we need to ask is: What are the possible returns of the stock market under each scenario?
Before examining the chart, let’s get a little knowledge about a few of the numbers that appear in the first two rows.
First we want to add up all of the companies’ earnings that make up the S&P 500 and compare them to the price of the S&P. In 2008 the S&P’s earnings added up to about $501. As of this writing the index of the S&P stands at just under 900, therefore a simple math calculation puts the price as a multiple of earnings to (PE) around 17.
