The Virtue of Complexity in Return Prediction
This article explores how researchers forecast market returns by aggregating expected returns from individual stocks.
This article explores how researchers forecast market returns by aggregating expected returns from individual stocks.
Since 2010, the S&P 500 has beaten the International Developed market in all but three years. This led the U.S. market to outperform International Developed by an astounding 8.14% compounded per year. Wowza! Talk about pain if you’re a global investor.
What matters is not the expectation of future growth, but the deviation between projected growth and realized growth, which, by definition is a surprise, and, thus, is not forecastable.
The hurdles to adding alpha for active managers are getting higher—investment practitioners make use of it as soon as or shortly after it is available.
Without question the topic of greatest debate among investors, including investment professionals, and financial economists, is whether or not the market, and the technology sector in particular, is overvalued. There are two very strong conflicting views regarding not only the current valuation of technology stocks, but also the valuation of the entire asset class of large-cap growth stocks. One side, I’ll call the “new paradigm” or “it’s different this time” school. The other side, I’ll call “the been there, done that” school. Its theme is those that don’t learn from the past are doomed to repeat the same mistakes. No two sides could have more different viewpoints. To understand each side, let’s imagine a dialogue between the two schools.
Making a bet on biotech/pharma firms that have not yet achieved significant revenue is the equivalent of buying a lottery ticket—with the same poor risk/return relationship.
For many benchmark predictor variables, short-horizon return predictability in the U.S. stock market is local in time as short periods with significant predictability (“pockets”) are interspersed with long periods with no return predictability.
Investment predicts returns because, given expected profitability, high costs of capital imply low net present value of new capital and low investment, and low costs of capital imply high net present value of new capital and high investment.
Consumer demand drives the cash flows of consumer-oriented companies. Thus, they should serve as a reliable source of information to predict future fundamentals above and beyond the information contained in financial statements and readily available market data.
Jack Bogle, the founder of Vanguard, created a simple explanation for predicting future stock returns. The so-called “Occam's razor” (law of parsimony) approach is an [...]
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