4/24/13 – Predicting the Stock Market

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 24, 2013 11:29:59 AM

and tagged Economics Lessons

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Is it possible to predict the stock market? As usual, it depends on what you mean. If you mean determining where the market will close today or tomorrow, or what a particular stock will do next week, the answer is no. It’s when you get into longer time frames, or larger portfolios, that things get interesting.

It also depends on what you mean by “predicting.” Are you, for example, looking at calling an exact number or just seeking an idea of likely outcomes? If the former, you’re out of luck; if the latter, you can probably make some headway.

What sparked this post was a series of discussions with several advisors here at the Commonwealth Leaders Conference. Our meeting planners have done their usual unbelievable job in terms of location and amenities, but what makes the conference really special is the people. Part of that is the opportunity to dive into important topics with a group of expert financial advisors.

With the market hitting all-time highs, the question has become, Is this sustainable? There are a couple of ways to look at it.

One, highlighted the other day in the Wall Street Journal article “One Way to Time the Market,” suggests that stock prices will not appreciate much in the next four years. The argument is based on Value Line analysts’ earnings projections, which, the article states, are actually easier to make over that time frame than a shorter one.

Another cautionary indicator comes from current valuation levels. I have written before about why I use a 10-year average price/earnings ratio, known as the Shiller P/E. At current valuations, from 1926 to the present, 10-year forward returns have ranged from −4.4 percent to 8.3 percent, with an average of 0.9 percent on a real basis, as reported in an AQR Research paper. The 0.9-percent average is pretty close to the Value Line results.

Assuming these two independent indicators are correct, returns over the next several years should be lower than historical average levels. This doesn’t tell us everything we need to know, however.

There are multiple ways you can get low point-to-point returns. Most simply, you can have prices stay stable or grow slowly. More excitingly, you can have great appreciation and then a correction—or possibly the reverse, with a correction and then appreciation.

We have seen all of these over the past 10 years or so, with the common denominator being that no one has consistently foreseen the next step. In the mid-2000s, the arguments were either that the upswing was justified and would continue, or that doom was imminent. The doom people were eventually right—but too early is wrong, and very few got the timing and the direction right. Similarly, at the bottom of the crisis, few got both the direction and the timing right.

The people who did get it generally right, including Jeremy Grantham, focused on the longer term. In keeping with the Warren Buffett quote “In the short run, the market is a voting machine, but in the long run, it is a weighing machine,” it’s easier to determine what something weighs rather than how people will vote.

Based on my own research, I believe that we can reasonably estimate future returns over multi-year periods, and that current valuation levels suggest they’ll be below historical levels. What we can’t, or at least I can’t, do is determine the path we will take to arrive at those returns. Looking at history, stable prices are probably the least likely route.

Given all this, caution with respect to equities seems warranted. With relatively low returns likely over the next several years, and volatility likely as well, I will be looking to manage risk in my stock exposure in multiple ways. While the costs of caution can be real, in difficult markets, they’re often less than the costs of not being cautious.

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