Valuation-Informed Indexing #112.

by Rob Bennett

I have a calculator at my site called “The Stock-Return Predictor.” I gave it that name for marketing reasons. It sounds mysterious and amazing and cool to be able to predict the future.

The calculator makes its predictions by performing a regression analysis on the historical return data. It identifies what the future stock return will be in the event that stocks perform in the future anything at all as they always have in the past.

The predictions cannot be wrong. In the event that we see very different returns than those “predicted,” the caveat that always applies to the work product of the calculator comes into effect. If we see things we have never seen before, the calculator isn’t supposed to work. And it won’t. So don’t look for me ever to say that there’s anything wrong with it!

Is there any benefit to a “prediction” that cannot be proven wrong? There is. Do you ever look at weather reports? They offer a sort of prediction, do they not? But like my calculator, the weather report cannot be wrong. It bases its predictions on what has always happened in the past under various sets of circumstances and identifies odds that the prediction will not come through. If the weather report says that there is an 80 percent chance that it will rain and it turns out to be a sunny day, the weather report was not wrong; it’s just that the one-in-five shot came through.

So it is with stock-return predictions based on the historical data. There’s never yet been a time when we have seen poor long-term returns starting from a time of good valuations or good long-term returns starting from a time of poor valuations. But the same starting-point valuation level does not always yield the same results. At times when returns are sure to be bad, we might see kinda, sorta bad long-term returns or absolutely frightening bad long-term returns. You need to know what the possibilities are. You are asking too much if you demand precise return predictions.

The funny thing is that it could be said that the calculator is predicting the past. 

There’s a fundamental reason why Buy-and-Holders find it so hard to believe that it is possible to predict stock returns effectively. To understand the difference in the two mindsets, you need to appreciate the different beliefs that Buy-and-Holders and Valuation-Informed Indexers hold re the cause of stock price changes.

Buy-and-Holders believe that each day’s price changes are determined by that day’s economic and political developments. That sure seems to be the case. We hear a report that inflation has increased and — Boom! — stock prices drop. The inflation news caused the price change! For sure! For sure!

Except it didn’t.

There are ways to test this sort of thing.

Buy-and-Holders say that it is only unanticipated economic and political developments that can change stock prices. Anticipated developments are priced in at the time they come to be anticipated. So it is only surprises that matter.

Surprise developments should not play out according to any pattern. We should see positive surprises and negative surprises popping up in all sorts of combinations. If the Buy-and-Holders were right about what causes stock price changes, stock price changes would follow a random walk.

They do not.

Oh, in the short term they do. That’s why I cannot tell you where the S&P 500 will stand next year at this time.

It doesn’t work that way in the long term, however. Long-term price changes follow a highly predictable pattern, one that has been repeating over and over again for 140 years now. Stock valuations go up and then up some more and then up some more. Eventually, they get so high that they crash. Then they go down and down and down some. Then they bottom. Then they start going up again. The entire process takes 35 years or so to play out.

It would be something close to a miracle for this pattern to repeat even once in a 140-year time period if stock price changes really were random events. The pattern has repeated four times. No other pattern has ever applied. The odds of that being the case in a world in which stock prices followed a random walk must be more than one million to one. It cannot be.

So price changes are not random events. They are predictable events.

What causes the patterns?

It cannot be unanticipated economic or political developments, as the Buy-and-Holder say. Those would fall into place randomly. Predictable changes can only be caused by some predictable force.

The predictable force is investor emotion. Investors love the idea of voting themselves raises. So they push stock prices up. Once they learn they can get away with it, they do it more frequently and to a greater extent. Prices go up and up and up.

But investors possess common sense. They understand on another level of consciousness that the phony price increases cannot last. At some point they come to feel that they have voted themselves too many raises. They scare themselves with the next price increase and then begin a process of pushing prices down, down, down. Until prices have traveled so far down that investors feel comfortable turning again to the idea of voting themselves raises.

Buy-and-Holders believe that price changes are determined by things that will be happening in the future. That’s why they dismiss the idea that anyone can predict stock returns. Who knows the future?

Valuation-Informed Indexers believe that price changes are determined by things that happened as far back as 10 years ago (decisions by investors to vote themselves raises that now are scaring those same investors). The market isn’t responding to the inflation report. Not really. The inflation report might be a catalyst for causing investors to act on emotions they were prepped to act on in any event. That’s why the same inflation report can cause either an upward or downward price move, depending on the day on which it occurs (investors primed to push prices upward see the inflation report as good news and investors primed to push prices downward see the inflation report as bad news).

I believe that stock returns can be predicted. Not because I have the power to look into the future. Because I have the power to look into the past!

Rob Bennett has written an article titled The Bull Market Caused the Economic Crisis. His bio is here.