As we move into 2016, just about every pundit in the world is offering his or her prediction on how stocks will fare over the coming year. But in a recent piece for Canada’s Globe and Mail, Validea CEO John Reese says those predictions are essentially worthless.
“That’s because so many factors go into short-term market movements that no one has found a way to reliably predict them,” Reese writes. “Not that they haven’t tried. In his 1984 classic Super Stocks, Kenneth Fisher wrote that people have attempted to divine market movements using astrology, demographic studies, sunspots, economics, technical analysis, tea leaves, and even ‘the skin of a dried lizard at sunset cast to the wind.’ But, Mr. Fisher said, while a forecaster might have a good of couple years, no one has found a way to consistently predict short-term market movements – and that still holds true.”
But, Reese says, longer-term projections do have some benefit. “Legendary Vanguard founder Jack Bogle, for example, has found that just three factors go a long way toward predicting where the market will be 10 years out,” he writes. “The first two of Mr. Bogle’s factors are dividend yield and corporate earnings growth, which comprise what he calls the ‘investment return,’ because they are determined by fundamentals. The third is ‘speculative return’ – that is, the change in what investors are willing to pay for each dollar of earnings (in other words, whether the market’s price-to-earnings ratio is rising or falling).”
Right now, that projected investment return is about 7%, Reese says, though he notes that a percentage point or two could be clipped from that if valuations come back down to historical norms. Reese takes a look at three stocks that he thinks are offering better-than-average opportunities. Among them: RV maker Thor Industries
The Wall Street Journal’s Money Beat column highlights the value of simplicity in investment prediction models. Profiling work by John C. Bogle, founder of Vanguard Group, that draws on historical data, the piece highlights his three-factor formula for determining the “sources of return.” These are:
- Starting yield (annual dividends divided by stock price)
- Earnings growth
- Speculative return (changes in pricing by investors)
The first two factors can be grouped together, according to Bogle, as “investment return” because they reflect what companies actually generate rather than speculation on pricing by the market.
“If you don’t like my numbers,” Bogle says, “you can put in your own.” In other words, the model is adaptable and may be simple enough for many individual investors to consider. Predictions about speculative return are particularly open to debate and have a significant impact on results.
Bogle’s bond model is even simpler. The key factor is yield to maturity (interest income divided by market price). Bogle found at least 90% of subsequent returns on bonds could be explained by their initial yields.
The Journal suggests “[y]ou can apply the same principles to any financial asset,” using commodities as an example. According to Ryan Larson of Research Affiliates, a diversified basket of commodities has historically had four key sources of return. These are:
- The “roll return” (renewing contracts over time)
- Interest earned on collateral to buy commodities
- Market price fluctuation
- Rebalancing (selling some of what has risen most to buy what has fallen most)
The latter two factors appear to make all the difference in commodities value recently, according to Larsen. Thus, as with stocks, predictions about pricing in the market (akin to Bogle’s “speculative return”) is crucial.
John Bogle, founder of Vanguard Group, has a pessimistic prediction for markets over the next decade. He says that he divides his expected return forecast into two segments: investment return and speculative return. For the first, he combines 2% dividend yield with estimated earnings growth of 6% to reach a total of 8%. However, his speculative return number then incorporates predictions about the price-to-earnings ratio, which he expects to fall from an estimated 20 times underlying value to about 15 times, yielding a speculative return of about 4%. For bonds, Bogle suggests that investors may be able to realize about a 3% return by buying longer-term bonds. He also notes that mutual fund fees, and investor behavior (such as buying high and selling low) are likely to reduce returns even further, perhaps as low as 1.5% or even to negative returns. At the same time, however, he notes that he has “always taken the conservative line” so returns may be significantly better than his estimate.
Jack Bogle, founder of Vanguard Group, has maintained a very simple personal investment strategy for many years: 60% U.S. stocks, 40% U.S. bonds. Now age 84, he has recently shifted to a 50/50 portfolio mix, explaining “I just like the idea of having an anchor to the windward,” and, “I’m not so much worried about having my portfolio grow.”
Bogle’s approach is based on a few broad principles. Research tends to support his view that a passive strategy to mirror the market is better for an investor over the long term (a controversial idea when he advanced it over 40 years ago). Bogle’s other principles are more controversial. He doesn’t believe in rebalancing — “If you want to do it,” he says, “once a year is probably enough.” He doesn’t invest overseas because “we have the best investor protections and legal institutions,” even though U.S. companies derive at least 50%of their revenue from outside the U.S., and even though Bogle’s firm, Vanguard Group, has produced research suggests allocating 20% of a portfolio overseas. Third, Bogle diversifies exclusively through bonds and has increased the allocation to bonds as he ages to protect against risks from a short-term drop in stocks. Research suggests that stocks are the best long-term investment vehicle, but that bonds protect against stock market losses that might coincide with times when the investor needs the money. Finally, Bogle recommends taking an approach that is “simple” because it reduces the investor’s worry and protects against emotion-based decision-making.
Legendary Vanguard Founder Jack Bogle says that the stock market’s gains over the past decade look reasonable — if you trust the accuracy of corporate earnings. And he doesn’t appear to.
Legendary Vanguard Founder Jack Bogle says stocks may well at some point face a “judgment day” that could mean big short term declines, but he’s not advising that investors try to time it.
Legendary Vanguard Founder Jack Bogle says not to worry about short-term issues like the recent emerging market turmoil. Over the long haul, it’s the performance of companies that will drive stocks, he says, and he thinks corporate growth is indicating stocks should grow 6% to 7% annually.
“In the long-term … all value [is] created by corporations, which means, in an odd way, stocks are derivatives,” Bogle tells CNBC. “They’re derivatives of the value created by our corporations.” He said he expects corporate earnings to grow by 4% to 5% going forward. Adding in current dividend yields of about 2%, he says that makes for projected returns for stocks in the 6% to 7% range over the long term. Bogle also said that valuations are “high, but not extremely high.”
Bogle also said that strong growth in dividends was an overlooked part of last year’s market surge. In fact, he says investors in general “don’t pay nearly enough attention” to dividends. And he talks about why earnings don’t mean as much as they used to when it comes to valuing stocks.
Validea’s Hot List portfolio is up 232% since its mid-2003 inception vs. 79% for the S&P 500. Check out its holdings here.