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What We Can and Cannot Predict About Stock Returns And Why

Beyond Buy-and-Hold #101

Here’s the graphic from The Stock-Return Predictor showing how stocks are likely to perform starting from a P/E10 value of 15 (fair value):

What We Can and Cannot Predict About Stock Returns
What We Can and Cannot Predict About Stock Returns

Here’s the Results Table:

What We Can and Cannot Predict About Stock Returns
What We Can and Cannot Predict About Stock Returns

I’d like to make 10 points about predicting stock returns that follow from an understanding of the information contained in that graphic and table.

1. We cannot predict short-term returns. Neither the graphic nor the table show any predictions for the stock returns that will apply in one year or five years or eight years. There’s a good reason for that. The results that you get when you do a regression analysis for those time periods are not statistically significant. People who say how they think stocks are going to do over one year or five years or eight years are guessing. You shouldn’t put too much stock in what they say. You should avoid short-term timing.

2. We can predict long-term returns. It’s a shame that we cannot predict short-term returns. If my calculator did that, I would be rich and famous. Still, we should be grateful that we do get statistically significant results for time-periods of greater than 10 years. That’s a big deal. What it means is that, so long as you are willing to commit to your investing decisions for at least 10 years, you can pretty much eliminate risk from the investing project by looking at this calculator before making allocation decisions. If you know what your return is going to be before you put your money down on the table, it cannot be said that you are taking on risk.

3. The range of possible returns at 10 years out is large. It’s a big deal that we can make effective 10-year predictions, But we need to be careful not to oversell what is possible. We cannot predict ten-year predictions with a great deal of precision. The Table shows that the most likely 10-year return when stocks are fairly priced is 5.61. But there’s a tiny chance (less than 5 percent) chance that the 10-year return could be as high as 11.61 and a tiny chance that the 10-year return could be as low as a negative 0.39 percent.

4. The precision of the predictions grows greater as the time-period lengthens. At 20 years out, the range of possible returns drops from 12 points to 8 points (the best possible return is 9.78 and the worst possible return is 1.78).At 30 years out, the range of possible returns drops to 4 points (the best is 9.43 and the worst is 5.43). At 40 years out, the range is 3.8 points. At 50 years out, the range is 3 points, At 60 years out, the range is 2.5 points.

5. The valuations effect is greatest at 20 years out. If you compared the results for when prices are at fair-value levels to what they are when prices are high or low, you would find that valuations make more of a difference at 15 years out than at 10 years out and that valuations make even more of a difference at 20 years out than at 15 years out. The correlation with valuations drops a bit at 30 years out and then drops more at 40 years out, 50 years out, and 60 years out. At 60 years out, valuations are not much of a factor.

6. The reason why valuations do not matter as much after 25 years is that a new bull/bear cycle has started by then. Stock prices move generally upward for about 20 years (as they did from 1980 through 2000) and then generally downward for about 15 years (as they did from 1965 through 1980). When the time-period you are looking at is longer than 20 years, you are seeing a mix of bull-period and bear-period results. The counter effect drowns out the valuation effect

7. This reality offers us clues as to when the current bear market will end. The bear began in 2000. So we might expect valuations to begin working their way upward (after another price crash) somewhere near 2015 . We might expect to see the next bull top somewhere near 2035.

8. The fact that returns can be predicted for time-periods of more than 10 years but not for time-periods of less than 10 years suggests something highly significant about what causes stock price changes. It is counter-intuitive that stock prices can be predicted for some time-periods but not others. This shows that it must be different forces influencing prices in the short-term and in the long term. It is investor emotions (which are unpredictable) that are the dominant effect in the short term but economic realities (which are predictable) which are the dominant effect in the long term.

9. Most investors are not aware that it is investor emotions that determine short-term price changes. If they were, they would change their stock allocations in response to big valuation shifts. And if they did that, prices would always return to fair value. This is huge. In a world in which most investors were aware of what the last 30 years of research says about stock investing, stock prices would always remain near fair-value levels. That is, price volatility would be pretty much a thing of the past.

10. Risk is optional today. If we do away with price volatility, we do away with risk. Yowsa! Investing risk is voluntary today. Let’s start teaching people about what the research says!

Rob Bennett believes that the first thing you must learn to achieve financial freedom is how to start saving money. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

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