2019 Stock Prediction

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Happy New Year! Hope 2018 has been a blast, and I wish everyone a fantastic upcoming 2019! It’s been a while, but I’m feeling inspired today to write. I want to revisit my stock market prediction at the beginning of 2018, and provide some updated comments on how I think the market will progress going forward. Typing this post now, I realize there is a lot more information to present then I intend to write (it’ll also become extremely lengthy), so if you have questions or want to to hear more, do feel free to reach out and I can elaborate more.

 
As a quick refresher, on Jan 22, 2018, I concluded my 2018 stock market prediction post with the following summary:

My prediction for the S&P500 index, and the U.S. equity market more generally, is the end of the current bull-market near the beginning of 2019 with a peak price level of ~3360 (with an estimated ‘max melt-up’ to ~3600 and an estimated ‘early stoppage’ at ~2800). An accompanying market crash is likely, with no end in sight yet to this next bear market (currently, at least through to 2027).

It turned out that indeed the market has been through some turbulent times in 2018, especially the latter half, with a peak S&P500 index price of ~2940 in mid-September of 2018, right between my levels for ‘early stoppage’ and ‘peak price’. Granted the range I provided is quite wide, so the actual peak price this year falling in that range isn’t too impressive, but I am quite impressed that the predicted timing of the top of this bull market has been correct (at least so far). Turning toward the second part of the summary, my prediction then and still now, is going forward for the next 10 years, I expect equities to perform very poorly with average annual returns near ~0%. This has yet to be proven true, but I did want to share two key points to show why I feel this will occur.

 

Point 1 – Valuation-Based Measure Predicts Poor Returns

First, below is the key chart that I used previously in the original 2018 post to make my stock prediction for 2018, except I have now extended the chart from 2014 through to 2019 using the updated data we have today.picture2As a refresher, the chart shows on the left y-axis the compound annual growth rate over 10 years (shown by the black line) starting from any chosen year indicated on the x-axis. On the right y-axis is an Allocation Score (shown by the red line), that corresponds to the degree of allocation to equities, which is reported quarterly from the Fed. To interpret the Allocation Score, we can see that a less negative score, which roughly means that current allocation of investments to equities is low, tends to result in high future returns, and vice versa for more negative scores, which translate into high current allocation to equities and poor future returns.

In fact, the correlation between the Allocation Score and Annual Return Rate over 10-years from 1951 to 2009 is 0.903! This can be seen by how close the predicted return rate (in red) tracks the observed return rate (in black). I also made one special addition to this updated plot. Technically, the annual return rates past 2009 have yet to be fully observed, so the observed return rate after the vertical dotted black line at the start of 2009 is imputed by setting the future SPX500 price to be the same as today’s price from 2019 to 2029. This way we can make use of as much data as we have – for example, for 2012, we do already have 6 years of results from 2012-2018, and then the last 4 years of results will be imputed to be 0% – to get a sense of how accurate the predicted annual return rate is likely to be beyond 2019 (the closer to 2019 we go, the less likely the actual observed annual return rate will be accurate, since more of each 10-year period is imputed at a annual rate of 0%). In any case, the key point is that the correlation observed up to 2004 was 0.911 when the relationship was first presented, and has continued to remain high (correlation of 0.974) in the future years from 2004 through to 2009 in this ‘out-of-sample’ period, suggesting the Allocation Score is potentially a reliable indicator of returns going forward. It currently sits at ~0% over the next 10 years.

 

Point 2 – Financial Conditions are Tightening

Second, the Fed and other central banks are raising rates and tightening liquidity via quantitative tightening or diminished easing. This means that the influx of ‘money’ into the system that has been a huge contributor to rising assets prices is drying up and reversing, which means economic growth must be able to supplement for that withdrawal of ‘money’ to keep asset prices at these high prices. Unfortunately, economic growth has been anemic at best in comparison to past boom periods. Another way to think of this is the default risk-free rate that the US government pays increased from 0% -> 3%, and many investors are likely to take money out of recently poor performing equities to obtain a much safer guaranteed return in US government bonds, because now there is actually an option to make risk-free money (remember before at 0%, you’re aren’t earning anything with the risk-free rate so you are forced to go to something riskier to get yield). There’s a lot more details here that I’m brushing over, but the key message is that financial conditions are tightening, which often precedes market crashes and recessions. Ray Dalio has a series of articles that does a great job of explaining this in his debt-cycle framework.

 

Summary

  • Due to this backdrop, I feel that now is NOT the time to be invested in equities, as the expected return rate of ~0% is too low to justify the risk. Chances are a market crash is forthcoming as the central banks around the world continue to tighten financial conditions.
  • To confirm this prediction, I would like to see economic indicators, like the ISM to continue lower (e.g., below 50% and into recession territory) and the US unemployment rate begin to increase. I would also like to see price confirm this prediction with lower highs and lower lows in a sustained high volatility environment.
  • I would be worried my prediction is incorrect if economic indicators continue to be strong, and the US reaches new highs on the back of a reversal from tightening to easing by the Fed (and followed by other central banks).
  • In the short term, it is very possible for the market to bounce as technical conditions are oversold, but I would sell the rally and not expect upside to be sustained in 2019. Ultimately, I expect the 2019 year-end stock price to be, at best, at its current level of ~2500 and more likely to be much lower.

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