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Basics: Who Predicts Next Year's Market Return?

Summary

Intro level discussion of how broad market return is determined, using S&P500 as an example.

Which research firms predict market returns most accurately.

Total return estimates for US equity market in 2018

As we are beginning a new year, a good topic to address is what to expect from the US equity market in 2018 and some detail to back those expectations – a look at the process of making these expectations, who makes them, and the tools involved. 

Bloomberg Terminal

I use a Bloomberg terminal, a high-end, professional software package that you will find in every research department of big money mangers. It has live data on anything that can be related to business interest, in other words, anything that can make money – company news, research reports, estimates, documents and filings, as well as tools to build models for testing and trading. 

In a moment, I will tell you what I can see on Bloomberg that will be useful for you this year. 

First, a little recap about last year. Let's take S&P500 as an example. Last year ended at 2673, as you can see highlighted in the graph.  

SPX price chart

Here is a table with calendar year returns. It shows that last year, we had a return of 19.42% without dividends and 21.59% with dividends.

SPX historic

How well did your accounts do? If you have investments that are all US equity, you should have returned that much, or if you have a mix, say 60% equity and 40% bonds, then let's do quick math. Considering that an average bond portfolio has returned about 3.5% (see next graph), a portfolio of 60/40 would return 1.4 (=3.5*0.4) + 12.9(=21.59*0.6) = 14.3% before your fees or commissions.

 US Agg

If you didn't have quite such a return, and would like to discuss what could be improved in your allocation, leave a comment or message me.

Now let's look at 2018. The return targets vary from 2750 by Morgan Stanley, 2800 by Bank of America, to 2850 by Goldman Sachs, and from current 2673 that means on average 2.8-6.6% growth, plus dividend yield of about 2%, adds up to 4.8 - 8.6% by the end of 2018. 

Where do these targets come from? Who decides on them? Let me show you.  S&P500 index consists of 505 companies. In the table below, they are ranked biggest to smallest, Apple being the largest one. 

SPX weightings

We can take each company’s corporate filings for the year, the annual report. In the report, on the income statement page, we can find net income and net income per share, which is total net income divided by the number of shares, and arrive at the metric called "earnings per share”. So for Apple, for example, the net income projected in 2018 is $58.160 Bln,

 AAPL NI

and Apple has 5.149 Bln shares, so earnings per share will be $11.4 for the year.

You can also check this number in other places - for example in the middle column of the following panel. So our math is correct.

AAPL shares I look at each company's projected income and number of shares outstanding, and find their earnings per share. Then I pro-rate all the earnings according the the weight of each company in the index. Apple, for example, has 3.8% in the S&P500 index, so it will contribute $0.434 to the earnings of the index. I add all earnings this way and arrive at next year's projected earnings of $145, which is a 21% growth from last year's $119.  

And just to clarify, all this is done automatically in my model that tracks all earnings data in real time, I don’t have to make manual calculations.

Now you know where these numbers come from. And when people talk about effect of the tax bill or other events? We look at each company in the index and calculate for instance, the impact of lowering corporate tax to 21% and effective 27% (from 39% combined federal, state and local tax), or repatriation of foreign profits in cash at 15%. We determine how much each company will save, arrive at a higher net income, divide this net income by the number of shares, to arrive at the earnings per share number, and add up those individual earnings per share.

Now you might think, "if it’s so predictable, how come index price won’t just go up to the full valuation right this hour"? The thing is, tax benefits and predictions are never reflected din the price. Companies always have variables determining returns, and as long as there is risk, earnings are never fully priced in.

Besides, a market correction could be triggered by an external event: a terrorist attack, nuclear attack, large scale selling by large institutional investors, significant slowdown in home sales or other economic indicators, or another significant negative unexpected event such as a large natural disaster. 

Overall, however, economic valuations are quite predictable, and this reasoning I have described above is what people are talking about when they say "company fundamentals look solid" and the bull market doesn’t have to end just yet. 

The total return range for 2018, 4.8 - 8.6%, is not going to be spot on, and all large companies that manage money, like JP Morgan, Bank of America, Goldman Sachs, UBS, Citi, etc, annually create their own projections and then compare who was the most accurate. These findings are published in the Institutional Investor magazine at the end of each year.

Looking back, Bank of America Merrill Lynch has had the most accurate predictions for 6 years in a low until 2017. Last year, JP Morgan had the top spot.

One last note. I said earlier, that earnings of the index will grow by 21%, from $119 to $139. That doesn’t mean that the value of the index itself will also grow by 21%, because the value of the index looks at multiple years out, not one year, and if there is slower growth in the future, then the value of the index will price it in, and grow less.  

I hope you have found this story easy to follow and helpful in getting a better idea of what you hear in the news. Feel free to comment, message, and suggest other topics for coverage.