Predicting the Future of the Stock Market Through Historical Values

by Dr. Steve Sjuggerud

Predicting the Future of the Stock Market Through Historical Values

by Dr. Steve Sjuggerud, Investment U Advisory Panelist

Saturday, December 7, 2002: Issue #196

"It is not natural for us to learn from history. Children will cease to touch a burning stove only when they are themselves burned; no possible warning by others can lead to developing the smallest form of cautiousness." -- N.M. Taleb in Fooled by Randomness.

What is the future of the stock market... Will the market be up or down five years from now?

Van Tharp asked people to write down their answer to this question at an investing seminar we held together this past weekend. The responses amazed me. In a packed house, all attendees but one said the market would be higher in five years.

If investors were rational beings, with any sense of history, the numbers should be just the opposite. To show you what I mean, I'll offer up what may be the most rational, history-backed answer.

With No Concrete Future Knowledge... Go With Historical Values

Since we have no concrete knowledge of the future, the safest guess for five years from now may be that the market will be in line with its historical values. Of course the market may be substantially higher than history would suggest or substantially lower.

I came up with the following figure - 41% lower - by looking at the three most time-tested measures of valuation:

  • The price-to-earnings (P/E) ratio

  • The price-to-book value (P/BV) ratio

Over history, the average value of these has been 16, 2, and 1, respectively. (I'm actually being a little generous, here, so I can't be accused of being a bear or fudging any numbers.)

All I could assume was that these numbers would be roughly in line with history five years into the future from now. In that same spirit of history, I assumed that sales, earnings and book values will all increase by 6% a year for the next five years, again, (very) roughly in line with historical averages. Based on that, the S&P 500 would be at 530 in five years - or 41% below its current value of 900.

Do You Have to Burn Your Hand on the Stove to Believe?

So what should we make of this? I think hedge-fund manager N.M. Taleb hit the nail on the head in his book. He basically said that until investors have personally burned themselves on the stove, they won't believe they can get burned. Taleb explains:

"All of my colleagues whom I have known to denigrate history blew up spectacularly. I have noticed plenty of analogies between those who blew up in the crash of 1987, the Japan meltdown of 1990, the bond market debacle of 1994, Russia in 1998, and in buying Nasdaq stocks in 2000 They were all unable to accept that the experience of others was out there, in the open, freely available to all, with books detailing crashes in every bookstore. Aside from these generalized systemic blow ups, I have seen hundreds of options traders forced to leave the business after blowing up in a stupid manner, in spite of warnings by the veterans, similar to a child's touching the stove."

In short, a room full of investors didn't think the market would be lower in five years because of their historical experience - it's never happened to them. Put simply, they've never burned themselves on this particular stove.

However, many U.S. investors throughout history have been thoroughly burned on this stove many times. Twice in the 20th century (after 1929 and after the late 1960s), it would have taken you over 25 YEARS to break even in stocks, when you account for inflation. What's worse, stocks today are still more expensive than they were in either 1929 or the late 1960s, even after they've fallen in recent years.

Lessons from the 19th Century

In the 19th century, forget about it - there was a 50-year stretch AND an 18-year stretch where you'd have done nothing but lose money in stocks (and that doesn't account for inflation). In what is no doubt a surprise to most investors, the stock-market index's compound annual gain for the 19th century was 0.80% - less than one percent per year (that is the gain of the index, which does not include dividends).

I've been studying this particular "stove" my whole career. It's my job to know how it works, through and through. I've crunched more historical numbers than anyone I know. So if my life's work is worth anything to you, it's that I can surely tell you if the stove is hot

The stove is hot right now.

Are you going to choose to ignore history, and get burned like everyone else? Or are you going to accept that someone who's spent his entire career answering this question knows what he's talking about, and plan accordingly?

The choice is yours...

Good investing,

Steve

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