Every retirement calculator depends on being able to forecast a return on investment. We have been told that the stock market averages 10% a year. Some will even go as high as 12% a year. The higher this return on investment the less money we need to invest or the more money we have to retire upon. The question we really need to ask - Is this reasonable over the next 10 years? I use 10 years because that is long enough a time frame for compound interest to works it magic and for many of us to develop our attitudes toward the stock market.
Recent Performance We are an MTV ADD society. We focus on quick, recent and now. So what has the market done recently? WOW Over a 50% return in around 6 months. Now if I project that into the future for the next 30 years (this is what retirement calculators do) then I will be a gazillionaire working at McDonalds. Does that make sense to anyone? So why do we assume that the market will return a steady 8,10,12% return for planning our retirement? Is this recent performance a sign of a new Bull market?
From a short term perspective, this run is probably about done. Several reasons help us to see that. For purposes of this discussion I will stick with the S&P500 which a gives a fairly broad overview of the entire market performance. I used www.stockcharts.com and the symbol $spx to determine these findings.
1) Volume - Volume is the the number of shares traded on the stock market each day. Strong bull markets generally see rising volume as more and more people want to buy. This rally had its peak in March when the market hit a bottom and has been on a steady decline since then. It is like a game of musical chairs. Everyone is still playing until only one is left... then the game is over. So slowing volume is not a strong sign to support the continued run in the market.
2) Seasonal What is the worst month for stock market performance? Not counting last year, September has averaged a return of -1.5% (That's a negative return). Last year we all remember September being a very bad month which would only drive this number further into the negative. October is not as bad a month of average but has been the location of most of the major crashes in market. I am not suggesting we will have a crash in the market this October, just that for the next 60 days we have a downward bias in the market. Now seasonal also occurs in more than months. There are a lot of theories out there that we have an 50-100 year cycle that also impacts the stock market. These theories put us going into a "winter" cycle which suggests much lower prices going forward. I'll be honest, I am just now digging into the facts behind their theories so won't make any claims regarding them. If you are interesting in reading some of them just google Kondratieff Winter. Just make sure to not have any sharp objects handy if you have never looked at something like that before. It can be slightly depressing until you realize they do talk of a cycle, so spring comes after winter 
Ok what about for a little longer than 60 days. Most of us invest in the market for more than just 60 days. What about the next 16 months?
3) Presidential Cycle The biggest driver for next year is the presidential cycle. For a good article on the presidential cycle The Big Picture is an excellent economic blog if you want to deepen your knowledge of economics. I won't say it is exciting reading unless you like economics. Notice also this has nothing to do with President Obama's policies. The data covers both Republican and Democrat presidents. It shows a negative return in the second year of the presidents term with some being very large decreases. It's not a perfect indicator as at least a couple of 2nd year's were positive with over 14% gains. It generally shows that the end of the 2nd year of a president's service is a good time to buy the market. So keep that in mind.
4) Artificial Stimulus We are coming to an end of many of the artificial stimulus plans. The First time Home buyers credit is set to expire in the next couple of months. Cash for Clunkers ended recently. I know they want us to believe that these programs have fundamentally supported the markets but in reality they have simply pulled buyers forward. Buyers of the cars have now traded something they owned for something they owe on. Long term that will be a drag on future spending. At least the home buyers have an asset but expect home sales to decline as the credit disappears. The Fed also has no room to juice things through lower interest rates. They are for all intents and purposes negative today. Like an athlete who is using short term performance boosting drugs, when they wear off, performance drops.
So what about longer term? I mean I invest in the market for the long term. How about 10 years? Is that long enough? Why the next 10 years may be more of the last 10 years.
Two Major Drivers of the Stock Market
1) P/E Ratio P/E Ratio is the Price to Earnings Ratio. Price is pretty straight forward. It is the price that the stock or index is trading at. Usually an average price is used to help smooth things out. Earnings is a little more complicated. You would think that earnings would be straight forward as well but its not.
The first question you have to answer is what time frame you are going to use. Trailing twelve months? This tends to show growth stocks in a poor light since their earnings are growing dramatically. It also shows a declining stock in a better light since the last twelve months could have been its best ever. What about forecasted earnings? This helps to solve both problems. Yet it also adds a new one. Whose forecast? How accurate will they be? History has shown us that the only truth a forecast has is that it will typically be wrong.
The Second question - How do you calculate earnings? Wait a minute. Don't we have rules for that? Yes we do. They are referred to as GAAP (Generally Accepted Accounting Practices) but many companies also like to report operating earnings. Operating earnings are GAAP earnings but they remove one time or special expenses from it so they generally show as being higher. Once upon a time there was little difference between the two but companies have been taking advantage of the rules to report higher operating earnings over the past decade.
So by now you are probably asking - Who Cares? I mean why do I care what kind of earnings, what time frame, etc. Does P/E really matter. Kansas City Fed Report is a report published by the Kansas City Federal Reserve Bank. It discusses the importance of P/E ratio to future performance of the stock market. The researchers basically analyzed data for the S&P looking at P/E ratio and the 10 year performance of the stock market. The study was done by a Yale and Harvard professor. It showed a correlation between P/E ratio and future performance.
Higher P/E Ratios led to lower gains over the next 10 years. If you bought when P/E ratios were in the highest quintile, your return over the next 10 years was roughly zero in real dollars (adjusted for inflation). Where are we today? Using the same numbers they did put us pretty close to the top quintile. Their numbers can be found here in graphically form. So either prices decline or earnings go up to get us back to an average level.
Reversion to the mean In a study of complex systems, they always revert back to the mean or average. It overshoots and comes back to the mean, it undershoots and comes back up to the mean. Growth in earnings averages around the gain in GDP. If we grow beyond that for a while, then we have slower growth later to adjust for it. We have spent the better part of two decades from the early 1980s to the late 1990s exhibiting faster than normal growth in earnings and P/E ratios. Now we can expect a similar time frame of slower growth. Based on what you know of the economy in your area, do you really expect companies to have dramatic growth over the next 5 years?
So what else drives the market besides P/E ratio?
PSYCHOLOGY The stock market is the ultimate example of applied psychology. People drive the markets. If the majority of people believe that the market is great place to be, then it continues to go up even past historically reasonable levels. Since we have experienced a tremendous bull run during the 80s and 90s most investors have a fundamental belief that the stock market is the place to be for growth. The last 10 years has begun to weaken that belief somewhat but talk to your friends and neighbors. They will still tell you they are investing strongly or are looking to get back into the market.
Having talked to some people who worked in the financial arena during the late 70s and very early 80s, they tell of stories where people wouldn't touch stocks. They were an unwanted class of investments. That is what typically determines a bottom in stock prices. Do you see that attitude around you? Or are people waiting to make their money back in the market? So what happens as time drags on and the market drifts sideways or drops some more? The psychology of new investors starts to change.
Once the psychological mindset of investors start to change, we see a fundamental shift in how the market performs. Any one who started invested 10 years ago doesn't see the market the same way as someone who invested in the 80s and 90s. They will make decisions very differently. As Baby Boomers near retirement, their risk tolerance becomes significantly lower. They will transition into lower risk products like municipal bonds.
Fundamentals and psychology both point to a sideways or downward drift in the stock market. Is that really where you want to put your future? Tell me what you think? I am always interested in alternative viewpoints.
PS We will continue our discussion of business structure tomorrow on Partnerships. Join our newsletter to make sure you don't miss a thing.
Here's a previous article I wrote on Stock Market Prediction 2009
PSS If you thought this was worth anything give it a Digg!!
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