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As my readers are aware, I put considerable weight on the market-implied outlook, a probabilistic forecast calculated using options prices. Almost exactly 12 months ago, the market-implied outlook for the S&P 500 (calculated using options that expire on January 21, 2022) indicated that the highest-probability outcome was a total return of 10.5% for the year. The estimated 90th percentile price return for the year was 21%. The expected volatility was 22.8%. This was a bullish outlook. The actual total return of the S&P 500 over the past 12 months is 26%.

I have updated the market-implied outlooks for the S&P 500 (using SPY) for 2022 and into the start of 2023. Before looking at these outlooks, however, I provide some background on how these are calculated and considerations in interpreting them.

The prices of options on an index ETF (SPY, in this case) reveal important information about the market’s consensus outlook. The price of an option on SPY reflects the market’s consensus estimate of the probability that the share price of SPY will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires. By analyzing the prices of call and put options at a range of strike prices, it is possible to calculate a probabilistic price outlook for the period between now and the expiration date. This probabilistic outlook reconciles the prices of the options and represents the consensus view of buyers and sellers of options. This is referred to as the market-implied outlook. I have written an overview post on this approach and I suggest that quantitatively-oriented readers read this excellent monograph published by the CFA Institute.

I have been running market-implied outlooks for stocks and ETFs for several years now. This is possible thanks to liquid options markets and burgeoning computer power. Back when this technique was first demonstrated in the late 90’s, pioneered by Mark Rubinstein and Jens Jackwerth, options markets were less mature and computers were much slower. Today, I can run a market-implied outlook using my laptop. The key to the process is to figure out an empirical probabilistic forecast for the price of a stock or ETF, such that options priced using this distribution are as close as possible to the market prices of those options. This is an optimization problem. The market-implied outlook does not assume a specific distribution of returns, but instead determines a distribution that can explain the observed prices of options. It is well understood that observed properties of options prices, notably the volatility smile, are problematic for simplistic options models such as Black-Scholes and its variants. Calculating a market-implied outlook is a way around this issue. What is most remarkable to me in looking at the market-implied outlook is that option prices calculated from these outlooks typically match the observed options prices to well within 1% of the market prices.

I have written a range of articles on market-implied outlooks at Seeking Alpha and I also published an extended article and market outlook in Advisor Perspectives in early March of 2021.

I have calculated market-implied outlooks for four expiration dates spanning the next 12 months. The outlook calculated using options that expire on March 18, 2022 provide a 2.09-month forecast. The outlook calculated using options that expire on June 17, 2022 provide a 5.07-month forecast, etc.

The standard presentation of the market-implied outlook is in the form of a probability distribution of price returns, with probability on the vertical axis and return on the horizontal axis.

Geoff Considine*Market-implied price return probabilities for SPY for the 12.16-month period from now until January 20, 2023 (Source: Author’s calculations using options quotes from ETrade)*

The market-implied outlook for the next year, calculated using options that expire on January 20, 2023, is consistent with the prototypical form that we expect for broad equity index ETFs. There is a well-defined peak at a positive return and a long asymmetric negative tail. These distributions are negatively skewed. This distribution is consistent with the standard volatility smirk (also see this paper), with the highest implied volatilities associated with out-of-the-money put options. The maximum probability outcome is a price return of +9.8% for this 12.16-month period. The annualized volatility calculated from this distribution is 21.4%. This is a bullish outlook for SPY over the next year.

Theory suggests that the market-implied outlook is expected to be negatively biased because investors, who are risk averse in aggregate, will tend to pay more than fair value for downside protection (put options). This effect would also tend to exacerbate the negative skewness observed in the market-implied outlook. Put differently, the market-implied outlook would represent an unbiased outlook only if investors were risk neutral rather than risk averse. While it is impossible to diagnose the actual impact of risk aversion on the market-implied outlook, knowing that we expect a negative bias makes this outlook even more bullish.

While Wall Street analysts often discuss their predictions in terms of a single price target, it should be obvious that a probabilistic outlook is far more meaningful. Looking at the distribution, however, it is clear that the range of likely outcomes is quite large. A useful way to discuss the probabilities of specific outcomes is in terms of percentiles, another view of the market-implied outlook.

Geoff Considine*Market-implied percentiles of price returns for SPY for the 12.16-month period from now until January 20, 2023 (Source: Author’s calculations using options quotes from ETrade)*

The market-implied outlook indicates that there is a 61% probability that SPY will have a positive price return over the next 12.16 months. The 90th percentile price return is +20.4% and the 10th percentile is -30.3%. The median price return (the 50th percentile) is +5.3%.

The interesting question, of course, is whether the options market is smart or is just betting on long-term averages. The 15-year annualized total return for SPY is 10.4% per year and the annualized return from 1926 through 2021 is 10.49%. These values are close to the market-implied outlook’s peak probability price return of 9.8% plus SPY’s 1.2% dividend yield.

The summary statistics for the market-implied outlooks through 2022 and into early 2023 tell a consistent story. The peak probability price returns grow steadily with the term of the outlook. The annualized volatilities for the different outlooks are very stable, with a slight upward trend.

Option Expiration Date

Length of Outlook (Months)

Maximum probability price return

Volatility

Annualized Volatility

3/18/2022

2.09

3.3%

7.7%

18.4%

6/17/2022

5.07

5.6%

13.3%

20.4%

9/16/2022

8.04

7.9%

17.2%

21.0%

1/20/2023

12.16

9.8%

21.5%

21.4%*Statistics for market-implied outlooks over the next year (Source: Author’s calculations)*

The market-implied outlooks for the S&P 500 over the next 12 months looks quite favorable, with the maximum probability corresponding to a price return of 9.8%, for expected total return of about 11%. This is far lower than the S&P 500’s average annualized returns in recent years (3- and 5-year annualized returns of 24.1% and 17.8%, respectively), but is in line with the long-term averages. The market-implied outlook for the S&P 500 represents a favorable risk-return tradeoff, with moderate expected volatility.

Geoff Considine*Market-implied price return probabilities for SPY for the 2.09-month period from now until March 18, 2022 (Source: Author’s calculations using options quotes from ETrade)*

Geoff Considine*Market-implied price return probabilities for SPY for the 5.07-month period from now until June 17, 2022 (Source: Author’s calculations using options quotes from ETrade)*

Geoff Considine*Market-implied price return probabilities for SPY for the 8.04-month period from now until September 16, 2022 (Source: Author’s calculations using options quotes from ETrade)*

This article was written by**Disclosure:** I/we have a beneficial long position in the shares of SPY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.