God is a Capitalist

Monday, September 2, 2013

Stock Market Forecast

"It is difficult to make predictions, especially about the future,” said Mark Twain.

But, investors have no choice but to attempt to forecast the stock market. Ludwig von Mises wrote,

"Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers. "[1]

The investor is the entrepreneur and must forecast future prices of stock, even if only to adjust his allocation of funds between stocks, bonds and cash.

Here is my lasted forecast of the S&P 500 for the next two quarters. The upper and lower lines are the upper and lower ranges of the prediction interval, that is, where the model predicts the S&P 500 will be. The middle, blue line is the historical value of the index.

The model uses quarterly profit data from the Bureau of Economic Analysis to predict the quarterly average of the S&P 500 because only quarterly data for profits is available. Of course, daily, weekly and monthly averages will vary considerably around the quarterly average, but the model can give a general idea of market direction.

 The graph shows that the market has followed the model relatively well. For geeks, the model regresses year-to-year changes in the S&P 500 on year-to-year changes in two profit variables. Data in the form of year-to-year changes gets rid of the trends. The model explains about 45% of the variation in stock prices, which is a pretty good model for detrended series such as these. Leaving the trend in the data would have made the model fit better, but it would forecast poorly.
Risk tolerance explains most of the rest of the variation in stock prices. The price/earnings ratio measures risk tolerance. For example, a PE of 20 says investors are willing to take more risk (pay more) for the same earnings. In the later stage of a bull market, stock prices will rise even though profits don’t because investors are willing to pay more. The market outperformed the model in the late 90’s because risk tolerance, and therefore PE ratios, was very high. PE was as high at 40, whereas today it’s closer to 18.
 The model predicts a major drop in the quarterly averages for the third and fourth quarters. Historically, September and October are two of the worst months for the market. So be careful.  

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