December 20, 2013

What We Can and Can’t Predict About Stock Returns

Research Affiliates’ chief investment officer on the limits of forecasting

Nobel Prize winner Robert Shiller. (Photo: AP) Nobel Prize winner Robert Shiller. (Photo: AP)

Given the stock market’s propensity to humiliate those who dare predict its course, it is especially ironic that 2013’s dazzling returns come in the same year the Nobel Prize was conferred on economists whose work forecasted quite opposite results.

That is the message of Research Affiliates’ chief investment officer, Jason Hsu, in the investment research firm’s December “Fundamentals” newsletter, which notes that 2013’s near 30% stock market returns are at odds with Nobel laureates Eugene Fama’s and Robert Shiller’s award-winning asset-pricing models.

While the two economists’ approaches are very different, even opposite, Hsu argues that both “conclude that market valuation ratios forecast five-year returns with satisfactory accuracy.”

Again, despite their many differences, both would agree that high P/E ratios and low dividend yields reflect high equity demand.

“This willingness to bid up prices must, at some point, result in lower-than-average future return,” writes Hsu, who notes that the Shiller cyclically adjusted P/E (CAPE) ratio “spectacularly forecasted the carnage of the 2000 tech bust and the 2008 global financial crisis.”

And yet 2013 has proven a brutal year for anyone cautious enough to avoid stocks back in January when the Shiller CAPE was at 21 and trending still higher, despite a long-term average of 16.5.

That ratio implied an outlook for stocks ranging from neutral to extremely overvalued, whereas the outlook one year back for emerging markets was precisely the opposite — attractive to extremely cheap based on a then below-average Shiller CAPE.

And yet we find that “contrary to CAPE-based expectations, U.S. equities outperformed EM equities by roughly 33%,” Hsu writes.

The Research Affiliates principal quotes a wag who said “an economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”

That lesson on the limits of forecasting bears on today’s market predictions. Hsu cites a CFA Institute survey showing 71% of respondents expect equities to be 2014’s best performing asset class; just 54% held that view one year ago.

While Hsu believes the survey response reflects a well established tendency to project current trends into the future, he acknowledges that the stock market could indeed rally in the coming year, however improbable that would be through the Shiller CAPE’s lens.

Hsu concludes by warning of a danger he believes is borne out empirically:

“What is, however, forecastable with a great degree of assurance is that if the U.S. equity bull market continues into the first half of 2014, many investors will pour more cash into equities and fire managers who have underweighted U.S. stocks.”

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Check out Shiller vs. Fama: Which Nobel Winner Comes Out on Top? on ThinkAdvisor.

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