Forecasting Stock Market Returns Is Really Easy

by: Ronald Surz
Summary

Returns on stocks and stock markets are the result of just three factors, two of which are easy to predict.

The hard factor to predict is Price/Earnings ratio because it is driven by investor psychology.

All you need is a P/E forecast and you’ve got a forecast of market return. It’s that easy.

There are only three things that matter in forecasting future market returns. For a history of the behavior of these factors, and where they stand today, please see this Crestmont Research report.

Two years I ago, I published my forecast for 2017 market returns. I was way off because I did not believe that P/Es could increase all the way up to 30, as they did. This time I take the position that 30 may be the norm in 2018, but P/Es could revert to the mean of 20. You’ll see what this means for 2018 returns. But more importantly, I provide a table that translates your P/E forecast into a return forecast. You can make your own return forecast for 2018, and it’s easy.

The following formula is always correct because it is a tautology. To predict the future, simply estimate earnings growth and P/E expansion or contraction, which is driven by investor behavior.

Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1

The following table shows where we are now and highlights where we will be if P/Es revert to normal.

As you can see, the 2018 market return will be 8% if P/Es are unchanged, but the market will lose 28% if P/Es return to their historic mean of 20. And a P/E decline to 25 produces a 10% loss. As you can also see, if earnings do not grow at the anticipated 6% rate, market returns will adjust, but not as dramatically as the response to P/E expansion/contraction.

What is your outlook for earnings growth in the stock market over the next 12 months? Where do you see P/Es a year from now? You can look up your cell (forecast) in the table above.

Be aware that we are talking about market timing here. Risk management is a related but different topic.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am the originator of the 1st and only Robo Analyst that integrates Age with Risk. Age Sage builds better asset allocation models that help Baby Boomers transition through the Risk Zone that spans the 5-10 years before and after retirement. Implementation of these models can be done for less than 6 basis points. Boomers are poised for a sucker punch that they’ll never shake off.