Do Strong Fundamentals Predict Stock Market Returns?
With the recent stock market crash, you may be wondering how to predict stock market returns.
Do you think it’s possible to predict stock market returns?
Stocks can remain overvalued for a long time before a crash. For example, back in 1996 former Federal Reserve chairman, Alan Greenspan wrote about irrational exuberance driving stock prices up to unsustainable levels. He claimed the markets were overvalued and implied they could not keep up their tear. Yet it took several years for the dot-com bubble to burst and stocks to return to more reasonable valuations.
Clearly, Alan Greenspan understood stocks were overvalued in the late 1990’s, yet even the Fed Chairman couldn’t predict future stock market returns.
There’s been periodic discussion of an overvalued stock market during the recent rise in stock prices from a low on February 1, 2009 of $73.99 to the high of $212.00 on several occasions this year. (As measured by the SPY ETF)
If fact, I asked this question over one year ago.
Can You Predict Future Stock Market Returns?
If you’ve spent any time listening to the CNBC talking heads, you’ll notice a variety of future stock market predictions. And pick up the latest copy of Money Magazine, Kiplinger’s, or Smart Money for another batch of stock market predictions. I hate to admit that on occasion even I make a stock market return prediction.
Successfully predicting stock market returns not once but over the long haul is difficult, dare I say impossible. There are the momentum investors, the chartists, the fundamental investors, and many stock market forecasters with unnamed strategies. All types of stock market investors offer their future market predictions. One of the well known behavioral finance errors, overconfidence, causes many intelligent and not so smart investors believe they can read the tea leaves and predict stock market returns.
Intuitively, one would think that a company with strong fundamentals is a good stock purchase candidate. Yet, fundamental factors do not predict stock returns
“When it comes to predicting market moves, variables such as GDP growth, earnings trends, and profit margins are about as useful-and in some cases much less so-as tracking rainfall is.” According to Paul J. Lim in “Fundamentals? Forget About ’Em!”, Money Magazine, March, 2013.
Any long term investor knows its tough to predict future returns, but that doesn’t stop many from trying. Fundamental factors such as earnings and revenue growth along with profit margins and debt levels have long been assumed to predict future stock prices. The belief was that if a company is growing and profit margins are holding steady or improving and there are reasonable debt levels, then the stock price will rise. It sounds quite reasonable doesn’t it?
When Investing-Look at the Research
How do you know what works and what doesn’t? Opinion, gut, investing gurus, or your brother-in-law will not accurately predict the future stock market returns over time. But there are researchers who study the data and extrapolate information to inform modern investing practice. Recently, Vanguard senior economist Roger Aliaga-Diaz looked at data going back to 1926 and found that fundamental factors don’t drive returns. He posited that there are an abundance of other factors that drive returns above or below historical averages.
I’ve talked a lot about behavioral finance and your mind and money. Herd behavior and the actions of others can drive investors to dive into a stock or fund due to hype and group consensus. Just glance back at the dot com tech boom of the late 1990′s, or the more recent run up in stock prices-fundamental valuations had little to do with stock market advancement. Companies were bid up based upon hope and hype. Stock prices can continues to soar above true value as predicted by a company’s fundamentals. As we’ve seen this August, 2015, at some point stock prices will come back down to earth.
So what did the Vanguard study find? If fundamentals don’t predict future stock prices, then what does?
What Factor’s Predict Stock Market Returns?
Given that it’s impossible to predict the future with any consistency, how does an investor know when to buy?
According to Lim, valuations rule. No matter how great the balance sheet or how stellar the growth trajectory, if the stock is too expensive at purchase, you won’t make money on that stock! You need not only a strong and growing company, but you also need a firm which is fairly priced. And the way to measure the price tag of a stock is to look at valuation measures such as the price earnings ratio (P/E) to uncover a stock’s price tag.
The PE Ratio is a Price Tag
Here’s how to calculate a PE ratio. Divide the price by last years earnings (or just pull up a quote on Yahoo! Finance or any financial website) and you get the price earnings (P/E) ratio. Alone, the ratio doesn’t tell you much. But compare it with the industry average as well as the company’s own historical PE average and you have some actionable valuation information. If the current PE is significantly higher than the historical PE range and the industry average, the stock is expensive.
The Shiller PE ratio, as mentioned in the chart above, averages the last 10 years PE ratio of an individual stock or a segment of the stock market. This metric accounts for 43.5 percent of overall stock performance (according to the aforementioned research examining stock market performance from 1926 to 2012).
Fundamentals such as earnings growth and profit margins account for less than 1 percent of future stock price. For example, if Company BAF has a PE of 20 but all the other companies in BAF’s industry have a PE of 16, BAF may be overvalued or expensive. If BAF’s historical long term average PE ratio is 14 and its current PE ratio is 20, the company is probably overvalued. In sum, even if BAF has awesome growth and a solid balance sheet, the high PE ratio suggests BAF is overvalued.
What is the market prediction for BAF? The company is likely to return to a more historical PE ratio. That means that price is more likely to fall than rise in the future. (That is unless earnings, the bottom part of the ratio, explode and the price holds steady).
If you’re an individual stock picker, valuations matter! Although a high valuation won’t predict stock market returns, the PE ratio is a solid guide for an estimate of your future profit potential for a stock.
There’s an abundance of historical research supporting the outperformance of undervalued stocks. Valuation ratios also apply to mutual funds and ETF’s. Check out Morningstar or MSN Money for information about mutual and exchange traded fund PE and other valuation ratios. Just like you wouldn’t pay $50,000 for a Kia Optima, don’t buy a stock with a PE ratio of 24 if its historical average PE ratio is 14. The chart above illustrates that most other economic and corporate ratios offer little predictive value when looking to predict future stock market returns.
If you are among the investors who enjoy searching for undervalued gems, you might like one of my favorite investing books by Peter Lynch, One Up on Wall Street.
Data source; Vanguard-“Forecasting Future Returns; What Signals Matter and What They Say Now”, by Joseph Davis, Ph.D. Roger Aliaga-Díaz, Ph.D. Charles J. Thomas, CFA
Fess up, have you ever tried to predict future market prices?
What’s your success rate in predicting market movements?
A version of this article was previously published.