Tuesday, January 26, 2010

Projecting Stock Market Returns

What if We Could Predict Future Stock Market Returns?


Imagine that we could forecast whether our returns were going to be high, or low, before we invested. Imagine that we had an early warning system that warned us about upcoming bear markets or stock market crashes, and gave us a gentle heads-up when a bull market was imminent. This post is a step in that direction.

One important reason for doing analysis is to get insights that help us plan better. In the best cases, analysis results in an understanding so deep that you can predict the future -- or at least come very close under certain conditions. The obvious question is, can we use the results of the stock market analysis in the previous posts to help us make useful forecasts and plan our investments better? The graph below (click to expand) argues that we can.

Projecting 10-Year Stock Market (Dow) Returns

Stock market (Dow Index) 10-year forecast returns vs actual performance

In the graph above, each point on the solid blue line represents the annualized returns of a theoretical investor who bought the DJIA (Dow Jones Industrial Average) at the end of that year and sold 10 years later, reinvesting dividends throughout. For example, the last "start year" on the blue line is 1999; an investor who bought the Dow at the end of 1999 and sold at the end of 2009 would have earned an average annual return of 1.3% per year. (Note: This total annualized return consisted of about 2.3% per year in dividends, partially offset by a loss of 1% per year in price.)

Each point on the dotted red line is the projected return for the next 10 years as calculated at that time. The last point on the red line is also 1999; in 1999, the projected return for the next 10 years would have been minus 2.5% 1.1%. (see note at end)

Stock Market Forecasts Don't Have To Be Exact To Be Useful


Whether the -2.5% -1.1% forecast return is close enough to the 1.3% actual return depends on your objectives. For my purposes, that is close enough to the actual results to be useful. I don't believe in market timing, but I do believe in tactical asset allocation. Therefore, I am not looking for a tool that will tell me when to sell everything, or when to bet the farm. Instead, I am looking for insight into when to take a little money off the table, or when to become a little more aggressive. Phrased another way, I'm not looking to make a killing in the market; I just want to avoid doing something really stupid.

In addition, I am in the market for the long haul. I am not looking for a model that attempts to guess what the stock market is going to do tomorrow, next week, or even next year. I'm comfortable with a ten-year planning horizon.

Current Projections

As a result, for me, the above test of this simple model seems promising. In future posts, we'll look at how the forecasting model works, and try to better understand its strengths and shortcomings.

The 10-year projection vs. actual graph is updated annually to add the most recent year. For the most recent version, see 2011 10-Year Stock Market Projection. Monthly updates are included in the Monthly Stock Market Update; these updates are prose only and do not include an updated graph. (see "Recent Posts" in the sidebar or the menu bar at the top of the page).



Note: In 2011 I made a slight modification to the methodology that tends to moderate the highest and lowest projections. Thus, the original 1999 projection was changed from -2.5% to -1.1%. The graph from the original backtest is retained in the appendix below.

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Related Posts

How the Stock Market Projection Model Works
The 10-Year Stock Market Projection


This work is licensed under a Creative Commons Attribution 3.0 unported license.

Last modified: 8/17/2011

Appendix.
Stock market (Dow Index) 10-year forecast returns vs actual performance

2 comments:

  1. That is nice with 10 year, but what about the years 6/6.5/7/7.5/8/9/11/12/13/etc...

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  2. Anon,

    Thanks for the comment.

    I picked 10 years because I thought it was a reasonable planning horizon for an investor (as opposed to a speculator). I thought performance over the next 10 years would be a reasonable indication of how fairly the market was priced at the time (vs., for example, being severely over or underpriced).

    I want to understand better the strengths and weaknesses of this approach over 10 years before considering other time periods. My gut says that results would be at least as good for 11, 12 & 13 or more years, but probably not as good for shorter periods (especially periods as short as 6 or 6.5 years).

    Al

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