Forecasting Market Returns is Really Easy

By Ron Surz Ron@PPCA-Inc.com, Originator of Age Sage

• Returns on stocks and stock markets are the result of just 3 factors, 2 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.

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 that I’ll cover in a future article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.