This is part of Morningstar's 'Perspectives' series, which features contributions from third parties such as asset managers, academics and investment professionals.
It’s that time of year again - when everyone becomes Mystic Meg and pretends they know what the next year holds for markets. Fortunately, for those making the predictions, by this time next year no-one will remember what they were because everyone will be too busy looking forward to 2014.
Behind all this crystal ball gazing there is a serious point, however. With the range of stock market returns ranging from a fall of more than 50% to a rise of more than 130% (adjusted for inflation) in the 110 years or so of data in the Barclays Equity Gilt Study, there is clearly merit in trying to unearth the characteristics of markets that are about to soar rather than slump.
Even if what you do merely increases your odds of success (we all know there are no guarantees, after all) then it is surely worth a go.
Vanguard Study: Some Surprises When Predicting Future Returns
So it was with great interest that I read about a study ranking stock market indicators by their ability to predict future returns. To be clear about the provenance of the study, it was carried out by a provider of passive investment funds (OK, it was Vanguard!) and so its conclusion may not come as a complete surprise: after looking at how well the tools predicted future returns, the report concluded that using them to make investment decisions was not a good idea. Passive funds are premised on the idea that both market timing and stock selection are too difficult and should be avoided.
I half agree with this conclusion. In the short-run market movements are pretty random and a highly-priced market, for example, can just as easily carry on rising (that’s what momentum investors count on happening) and a cheap market can remain in the doldrums. I only half agree, however, because I think that extreme valuations can be a guide to how well markets will do in future and even long-term buy-and-hold investors would be well advised to increase their exposure when markets are very cheap by historical comparisons and to ease back when they are expensive.
The measures that the report looked at were interesting for one good reason. They are all figures that an investor would know when they came to invest. That’s important because we know that most forecasts made by City analysts are extremely unreliable and a poor guide to future returns. Relying on historic figures takes at least one variable out of the tricky process of selecting investments.
The figures ranged from those which the report concludes are extremely unhelpful such as corporate profit margins, the level of 10-year Treasury yields and GDP growth. Certainly the last of these three has been shown to have little correlation with stock market returns, which is why fast-growing emerging markets can sometimes be such disappointing investments.
Two Useful Measures for Predicting Future Market Performance
At the other end of the scale, the two most useful measures are both related to the simplest of all valuation tools, the P/E ratio. This measures the relationship between a company’s earnings per share and its share price, with a high ratio making shares expensive and a low value cheap.
The study suggests, sensibly, that a measure which takes an average of earnings over a ten year period is more reliable than a simple one-year historic figure. And while even this measure is only a reliable guide 43% of the time it does rather confirm my point that a focus on basic valuation can at least stack the odds in your favour.
One measure which the study concluded was only reliable around a fifth of the time was a share’s dividend yield. I have to say this rather surprised me because one of my favourite books on investment (Contrarian Investment Strategies by David Dreman) makes exactly the opposite point that high dividend yields can be a very good indicator of future performance.
I like high and sustainable dividend yields as an indicator of value for a number of reasons. They chime with the fact that in the long-run income tends to contribute the lion’s share of total return to any investment. For me, the ability to pay a high and reliable income is also one of the best indicators of a company’s quality, so they also provide a margin of safety in my opinion.
One other indicator which the study ranked poorly was trailing stock market returns. Again, I am surprised by this because my own research into historic returns (again using Barclays’ long term data) is that long periods of severe underperformance do tend to lead to periods of outperformance. Specifically I looked at 10-year periods of underperformance and tracked the average performance over the subsequent 10 years. My numbers showed that so-called “lost decades” for stock market returns can indicate a good buying opportunity for long-term investors.
What my research and Vanguard’s both agree on is that there are no short cuts to investment success. In the end there is no substitute for hard work and detailed analysis. And the best route to investment success, in my opinion, is to start early and to stick with it.
However, investment is absolutely a game of averages. If you can stack the odds more firmly in your favour by dialing up your exposure when markets are cheap and dialing it down when they look toppy, that must make sense.
The author, Tom Stevenson, is investment director at Fidelity Worldwide Investment. The original version of this article was featured on Fidelity.co.uk.
Morningstar Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com.
Fidelity Disclaimer
Note the value of an investment and the income from it can go down as well as up, so you may get less than you invested and tax rules and allowances can change. The ideas and conclusions in this column are the author's own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security. Past performance is not a guide to what may happen in the future and the figures and returns in this article are purely to illustrate the author's points.
