You can’t predict stock returns. Future stock market returns will equal the current dividend yield (which we know), plus earnings growth (which we can reasonably estimate) plus or minus the change in valuations (which is totally unknowable). For an idea of how this works, take a look at the chart below, which showcases possible price gains for the Straits Times Index (SGX: ^STI) 10 years from now based on its current earnings figure of around S$234 per share. The chart takes into account earnings growth plus or minus change in valuations: If the Straits Times Index’s…
You can’t predict stock returns.
Future stock market returns will equal the current dividend yield (which we know), plus earnings growth (which we can reasonably estimate) plus or minus the change in valuations (which is totally unknowable).
For an idea of how this works, take a look at the chart below, which showcases possible price gains for the Straits Times Index (SGX: ^STI) 10 years from now based on its current earnings figure of around S$234 per share. The chart takes into account earnings growth plus or minus change in valuations:
If the Straits Times Index’s earnings could grow at 4% per year over the next decade and investors are feeling euphoric enough to award a price/earnings (PE) ratio of 20 for it, we’re looking at a 111% gain to 6,921 points from its current level of around 3,280. On the other hand, if investors were pessimistic and gave a PE of 6 to the index, investors could be looking at a painful 37% decline to 2,076 instead.
From this, it’s easy to tell how wide the dispersion in returns can be for any given earnings growth rate due to changes in the valuation of the index (i.e. the price earnings ratio). Valuations reflect people’s feelings about the future, but the unfortunate thing is there’s no way to know what people are going to think about the future in the future. How could you? If someone said, “I think most people will be in a 9.21% better mood in the year 2024,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.
But if a rough rule of thumb had to be created to predict future sentiment, it would be the simple idea that after booms come busts, and vice-versa. Markets move in cycles, but people forecast in straight lines, extrapolating the recent past into the indefinite future. Optimism peaks on the eve of a long period of misery, pessimism just as a new era of prosperity begins.
One of the best measures of sentiment in the USA is the US president’s annual State of the Union Address. There’s a reason for this: The president’s job is to pander to the mood of the day. His remarks rarely contain balance, nuance, or qualification. They reflect, almost perfectly, what the average American is angry or excited about.
If you dig through the history of these speeches, it’s fascinating how they provide a decent counter-indicator of what’s to come for the economy and stock market.
Take what President Clinton said about the US economy in 2000:
“We are fortunate to be alive at this moment in history. Never before has our nation enjoyed, at once, so much prosperity and social progress with so little internal crisis and so few external threats. Never before have we had such a blessed opportunity — and, therefore, such a profound obligation — to build the more perfect union of our founders’ dreams.
We begin the new century with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back budget surpluses in 42 years. And next month, America will achieve the longest period of economic growth in our entire history.
My fellow Americans, the state of our union is the strongest it has ever been.”
And what stocks did next:
Or what President Obama said in 2010:
“One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard. And for those who’d already known poverty, life has become that much harder. This recession has also compounded the burdens that America’s families have been dealing with for decades — the burden of working harder and longer for less; of being unable to save enough to retire or help kids with college.”
And what stocks did next:
Here’s what President Reagan said in the 1983 State of the Union:
“Our economy is troubled. For too many of our fellow citizens-farmers, steel and auto workers, lumbermen, black teenagers, working mothers –this is a painful period. We must all do everything in our power to bring their ordeal to an end. It has fallen to us, in our time, to undo damage that was a long time in the making, and to begin the hard but necessary task of building a better future for ourselves and our children.”
And what stocks did next:
Here’s what Lyndon Johnson said in 1967:
“The last 3 years bear witness to our determination to make this a better country. We have struck down legal barriers to equality. We have improved the education of 7 million deprived children and this year alone we have enabled almost 1 million students to go to college. We have brought medical care to older people who were unable to afford it. Three and one-half million Americans have already received treatment under Medicare since July.
We have built a strong economy that has put almost 3 million more Americans on the payrolls in the last year alone. We have included more than 9 million new workers under a higher minimum wage. We have launched new training programs to provide job skills for almost 1 million Americans. We have helped more than a thousand local communities to attack poverty in the neighborhoods of the poor. “
And here’s what stocks did next:
Check out what Calvin Coolidge said in 1928:
“No Congress of the United States ever assembled with a more pleasing prospect than that which appears at the present time. In the domestic field there is tranquility and contentment, harmonious relations between management and wage earner, freedom from industrial strife, and the highest record of years of prosperity.
The great wealth created by our enterprise and industry, and saved by our economy, has had the widest distribution among our own people, and has gone out in a steady stream to serve the charity and the business of the world. The requirements of existence have passed beyond the standard of necessity into the region of luxury. Enlarging production is consumed by an increasing demand at home and an expanding commerce abroad. The country can regard the present with satisfaction and anticipate the future with optimism.”
And what stocks did next:
Here’s what Herbert Hoover said about the economy in 1932:
“The unparalleled worldwide economic depression has continued through the year. …The losses, suffering, and tragedies of our people are incalculable.
Not alone do they lie in the losses of savings to millions of homes, injury by deprival of working capital to thousands of small businesses, but also, in the frantic pressure to recall loans to meet pressures of hoarding and in liquidation of failed banks, millions of other people have suffered in the loss of their homes and farms, businesses have been ruined, unemployment increased, and farmers’ prices diminished.”
Here’s what stocks did next:
Foolish Bottom Line
None of this is perfect and it shouldn’t be used as a timing device. But it’s another example of the hardest, yet most important, rule in investing: Future returns usually mirror current sentiment.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by Morgan Housel and first published on fool.com. It has been edited for fool.sg.