God is a Capitalist

Wednesday, June 15, 2016

How not to predict the stock market

Investing expert Bert Dohmen said that “Looking at earnings, dividends and P/E ratios in order to predict future stock prices are all a waste of time” in a recent Forecasts & Strategies email issued by the economist Mark Skousen. The email continued:
Dohmen explained, “If a P/E were meaningful for predicting future price performance, why is a stock like Facebook selling at a lofty P/E of around 90, and Amazon with a P/E of 300, both still highly recommended and rising, while other stocks, like Apple, with a low P/E of around 10, [are] declining and down 35%?”

He added, “Analysts tell us that ‘earnings’ are the most important thing affecting stock prices. Really?! Well, corporate earnings in 2015-2016 have had the largest decline since the crisis in 2009, but the DJI and the S&P 500 are within about 1% of making new record highs.”

Then Dohmen asked the all-important question, “So what is the major determinant of stock market trends?”

Of course, the answer is “future earnings.” Stock prices are always based on the forward-looking views of investors. That’s why high-priced stocks such as Facebook are selling for 90 times earnings. It also explains why Amazon is selling for 300 times earnings and Tesla is selling for $230 a share even though it has no earnings! Investors are upbeat about their future. Meanwhile, Apple is selling for only 10 times earnings because it’s not viewed as a growth stock anymore.
Dr. Skousen is a follower of the Austrian school of economics and a promoter of the Austrian Business-Cycle Theory (ABCT) in his excellent textbook The Structure of Production, so I have enormous respect for his opinions. But I’m having trouble with this one. After all, people said almost exactly the same thing in 2000 just before one of the largest market crash in history.

And what helps predict the future if not “earnings, dividends and P/E ratios”? Dohmen says a better indicator is to assess if “Investors are upbeat about their future.” Of course, that is the typical mantra of momentum or growth investing: what goes up must continue to go up. And that is true in the later stage of a bull market as last week’s post showed. Returns for value investing fall behind those of a momentum strategy during the last writhing leaps of the bull.

Dohmen is right that investors place more weight on future earnings that past ones, but forecasting earnings is a subjective art, not science, and few people do it well. Differences in assumptions, methods and data produce different forecasts and therefore differing valuations of individual stocks.

The risk tolerance of investors changes throughout the business cycle as well. More cautious in the days when the bull is climbing out of the pit of a recession, then swinging to river boat gambling just before the crash. Great tolerance for risk sends P/E ratios of the most popular stocks into orbit somewhere around Uranus.

Dohmen makes the same mistake as proponents of the Efficient Market Hypothesis who insist that if an investor can’t predict the exact day of market moves then any attempt at market timing is foolish. That’s a false dichotomy. Any prediction that is early by several quarters is better than a late one by a lot. Most investors would have earned much more with less nausea had they bailed out of the stock market over a year ago using bonds as their parachute.

And the fact that a prediction is wrong today does not mean it will never be right. History proves that a forecast of a major crash will eventually be correct. However, being a “perma bear” would be as disastrous as blinding oneself to bears. The best approach is realism: read the signs to see the approaching bear and bail out with a reasonable margin of safety.

History has shown that protecting what you have earned when the market crashes is more important than always riding the bull no matter what.

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