“"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.
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.
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