Further to my recent post (see The ABCs of financial planning), I promised that I would write about how to forecast stock prices. First, I want to put together my analytical platform. There is no way to anticipate the price tag on stocks and bonds over another few days or weeks. Nonetheless it is quite possible to foresee the broad span of these prices over longer periods, like the next three to five years.
These findings, which might appear both surprising and contradictory, were analyzed and created by this 12 months’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller. Quite simply, aiming to call the currency markets in the short term is very difficult work, but calling it long-term is relatively easy. However, there’s a right way and an incorrect way to forecast long-run equity market returns. Robert Shiller is well-known for his analysis showing that long-term stock real returns, i.e. after inflation, to be 7%. With CPI at 1.5%, the long-term stock earnings should be 8.5%, right?
There are a number of issues with that approach. First of all, will you live long enough or be patient enough to see those types of returns? The long-term chart below shows periods when the currency markets have been in multi-decade range-bound episodes. If you’re in another of those periods, your comes back may be subpar for an extremely long, very long time.
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- 268 LSI Corporation (NYSE:LSI) -52.0% 2.55 5.31
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Can you be that patient? Lancer Roberts, writing at Pragmatic Capitalism, made the same point. Stock profits depend on when you start. As the chart below shows, there are crazy variations in collateral price returns, though a long-term trend is discernible upward. Here’s Roberts’ analysis of 40-year stock returns by starting decade. Would you like to roll the dice on what you get? Most evaluation of stock returns have focused on US equities – which is suffering from a survivorship bias because the united states market is not the only market in the world.
Imagine that you wished to invest in the capital markets in the year 1900. The stock market was undeveloped and nascent, the major marketplaces where the majority of the global capital was spent was the relationship market. The bluest of the blue chips was the British bond market. Other developed markets included France and Germany.
Oh, yeah, remember the Austro-Hungarian Empire. If you wished to take more risk, you could have looked at emerging marketplaces such as Russia, the US, Canada, Argentina, and Japan. Fast 113 years forward, how did that portfolio workout? You understand what I mean by survivorship bias Now. Just how much would Dracula be worth?
Think about any of it this way, let’s take Robert Shiller’s assertion that equity real profits of 7% to be correct. 10,000 into the currency markets 500 years back. Assuming 3% inflation on the 500 years, Dracula’s prosperity he would have today would have 24 zeros after it. Destruction: The reason why Dracula might not be a super-tycoon is that within the last 500 years, a lot of empires went down and a lot of people got killed in some very nasty ways.