Investing–The New Rules: The Stock Investor’s Weather Report

The Stock Investor’s Weather Report

The weather report has a good track record in telling you whether it is going to rain tomorrow or not. Two days out, it is less reliable. Three days out, it is even less so. With investing, the investor has a better tool than a weather report:The Stock-Return Predictor.

The Stock-Return Predictor tells you your future stock return. Enter into the calculator the valuation level that applied in 1982 and the calculator tells you that you are going to see 10 years of super returns. Enter into the calculator the valuation level that applied in 2000 and the calculator tells you that you are going to see 10 years of awful returns.

It’s like a weather report for stock investors.; it tells you whether conditions are such that you need to carry an umbrella or can feel fine about scheduling a picnic.

With one big difference.

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The weather report has a good track record in telling you whether it is going to rain tomorrow or not. Two days out, it is less reliable. Three days out, it is even less so. Weather reports that purport to tell you what is going to happen three weeks from now have little value.

Weather reports do a good job in the short term and a bad job in the long term. With The Stock-Return Predictor, it is just the opposite. Short-term predictions of how stocks are going to do are so worthless that the Predictor doesn’t even try to make any. But it claims to be able to tell you what is going to happen ten and twenty years down the road. Huh?

Stock returns are determined by two very different factors. One of those factors (the economic realities that generate profits for the companies you are investing in) permits effective predictions. The other (human emotion) does not. Human emotion is the dominant influence on stock returns in the short term. Economic realities are the dominant influence in the long term. Hence, the long-term is highly predictable and the short-term is hardly predictable at all.

Actually, my guess is that, if we studied this matter in depth, we might find that weather reports work in a similar way. The weather report tells you what is going to happen tomorrow. It cannot tell you with much accuracy what is going to happen at 2:17 PM tomorrow.

Micro-level predictions don’t work because there are a large number of factors that determine both the weather and stock returns and there is no way of knowing in advance which one is going to be dominant at any one particular moment. But macro-level predictions work fine because it is possible to know in a general sense what sort of weather or what sort of stock return is most likely given the conditions that apply for a particular time-period.

The difference between predicting the weather and predicting stock returns is that a day or two out is all that it takes for the general realities to assert themselves when it comes to the weather while with stock investing it takes five to ten years for this to happen. Think of 2020 as “tomorrow” in the field of stock investing, and you won’t ruin your favorite jacket in an unexpected stock-price downpour.

When you use The Stock-Return Predictor as a help in setting your stock allocation, you are putting the odds on your side. Put the odds on your side and you are virtually certain to end up winners in the long run. But those who put the odds on their side often have to accept that suffering temporary setbacks is part of the game they are playing.

I argued in an earlier column that you don’t want to be the gambler in a casino, you want to be the house. Say that a gambler pulls a slot machine lever only 10 times. Is it a certainty that the house will end up winners? it is not! Even though the odds favor the house, it is entirely possible for a gambler who only pulls the lever 10 times to end up ahead. Ten pulls of the slot machine lever are just not enough tries for the statistical probabilities that favor the house to assert themselves and come to control the outcome.

How about if the gambler pulls the slot machine lever 10,000 times? In that circumstance, the house is certainly going to be the winner. Pulling the lever 10,000 times insures that the statistical probabilities are going to control the outcome.

So it is with stock investing.

Put the statistical odds on your side for 10 years, and you are almost surely going to be happy with the result. But there is no reason to have high confidence that one year or three years or even five years is going to be enough to put you ahead. Those who want the long-term probabilities on their side lowered their stock allocations dramatically in 1996, when prices first went to insanely high levels. But stocks didn’t begin performing poorly until 2000 and we didn’t see a crash until 2008. The statistical probabilities played out in the end, as they always do. But those waiting for them to do so had to exercise some patience before seeing their expectations met.

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ALSO at DBKP:
* Investing–The New Rules: Harness the Power of The Stock Return Predictor
* Investing–The New Rules: Get the Odds on Your Side
* Stock Investing: Much of Today’s Understanding is Primitive

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The Return Predictor performs a regression analysis of the entire historical record to determine to what extent valuations have always affected long-term returns in the past and then tells you with the push of a button what the story is for the particular valuation level that applies on the day you are considering a stock purchase. It will work so long as the assumption at the root of the project — that how stocks have always performed in the past tells us something about how they will perform in the future — holds true.

If you believe that stocks are going to perform in the future in ways in which they have never performed before, the Return Predictor is not for you. If you believe that what has always happened in the past is our best (but an imperfect) guide to what is most likely to happen in coming days, I think that you should be checking out what this calculator has to tell you before making any future investing decisions.

Oh, one more thing! Please take a look at the article of mine that
appears today at the Daily Caller. It’s entitled
“Can We Handle the Truth About Stock Investing?” and it’s hot.

Next Week: — My wife Boo tells me what she really thinks about my investing ideas!

by Rob Bennett
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