Predicting Future Stock Market Returns

2008 March 29

by Kyle

from → Economy, Investing And Investments

Nobody knows the future and there are no crystal balls, but that doesn’t stop people from trying to divine the future of stock prices. There have been many methods put forth over the years, most of them bunk. That said, there are several workable frameworks that have shown themselves to be reasonably accurate over the long term. Over the next two posts, I will outline both of these methods and give you an idea of how you may go about making your own forecasts. I’ll also examine some of the underlying assumptions made by each method and how different variables can lead to different conclusions. Finally, it should be noted that these forecasts are generally only reasonably accurate over the long term. We’re talking decades here, not years. There are no reliable methods for predicting short-term stock movements. Both of these methods are covered in one of my favorite investing books, All About Asset Allocation by Richard Ferri.

Method 1: Stacking Risk Premiums

All investments have risk. With no risk, there is no return. Intermediate-term corporate bonds have inflation risk, default risk, and term risk. Large-cap US stocks have equity risk in addition to all the risks of intermediate-terms corporate bonds. Small-cap value stocks have small-cap risk and value stock risk in additions to those possessed by large-cap US stocks. Starting with the risk-free US treasury bill rate of return and stacking risk premiums on top of each other, we can estimate future long-term returns for practically any asset class imaginable.

Method 2: Forecasting Stock Returns Using Macroeconomic Growth Factors

This is a top-down method in which you first estimate the future growth of the over-all economy using various marcoeconomic conditions and back out to determine corporate earnings. Since stock prices follow earnings over long periods of time, you can estimate with a fair degree of accuracy what stock prices will look like 30 years from now if your economic projections turn out to be true.