A Pessimistic S&P 500 Forecast for 2010-2012

It's probably appropriate that my first forecast for 2010 would involve the stock market. The US has gone through two stock market bubbles (the dot-com bubble from 1998--2000 and the subprime mortgage crisis from 2007--2010, hopefully) in addition to a direct terrorist attack on New York City (September 11, 1002) that paralyzed the financial system. Before presenting a forecast for 2010, let's look at how well my time series models dealt with this period of stock market instability.

The figure above displays a feather forecast of volume (the upper panel) and price for the S&P 500 (data from Yahoo! Finance). Although the models track the stock market data very well (displayed here), the feather forecasts (in this case, the feather forecast starts from every month in the sample and predicts forward three years) show that the S&P 500 was over-valued during the dot-com bubble, undervalued during 9-11 and over-valued again during the subprime mortgage crisis. In other words, using the models would have suggested a conservative investing strategy and warned of developing stock market bubbles.

The S&P 500 model is driven by the state of the US economy. Using financial terminology, the market fundamentals are determined by the state of the economy. Using systems terminology, the stock market is a hierarchical subsystem within the US economy. The three forecasts (dotted red, blue and green lines) in the graphic above suggest that the future will depend on the state of the US economy. Volumes will be flat while prices will either rally or remain flat based on the future of the US economy. Not really that surprising a range of forecasts.

When I use an actual forecast for the state of the US economy through 2012 as input for the model, the forecast is pessimistic: declining prices and increasing volumes, in other words, a sell off. You can compare my forecast to the one provided by the Financial Forecast Center here. Their forecast for prices also points downward (out to Jul 2010).

Of course, it's also possible to create an optimistic forecast for the S&P 500 based on a more optimistic forecast for the US economy and the usual disclaimers apply. We're at a point where uncertainty rules.