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A reader sent the following observation and question:
Your analysis gives John Hussman only a 42% stock market forecast accuracy grade. His recent analysis of the gains and durations of past bull markets indicates that it is somewhat late to expect much more gains from this bull market. Yet, both your models predict continued gains extrapolated to beyond 2007. Other than historic data that shows all bull markets eventually end, is there a duration after which it is not prudent to invest new money but to wait until the expected 10%+ correction?
Our response:
We assign no value to statements such as "the bull market looks tired" or "this bull market is long in the tooth." Sample size (the number of past major uptrends) is too small and data quality (for example, regarding the applicability of data from generations ago to the current market environment and the rigor of trend definition) is too suspect to forecast the market based on length of major trend. Regarding applicability, interrelated changes in the financial services industry, the legal/regulatory environment and information technology have likely altered both the real risks of owning stocks and investor attitudes toward risk.
Dr. Hussman cites a sample size of 12 (or maybe 14) bull markets with very large standard deviations for overall gains and price-earnings ratios (P/E). Such a small and dispersed sample would offer insight only in conjunction with a persuasive illuminating theory. Financial ratio mean reversion is not a theory; it's a weak empirical observation (weak in terms of specific values and timing). Biological metaphors ("tired" or "long in the tooth") may sometimes provide insights, but they are not theories of finance.
Recall these life-work lessons from Emanuel Derman:
"In physics, the beauty and elegance of a theory's laws, and the intuition that led to them, is often compelling, and provides a natural starting point from which to proceed to phenomena. In finance, more of a social than a natural science, there are few beautiful theories and virtually no compelling ones, and so we have no choice but to take the phenomenological approach. There, much more often, one begins with the market's data and calibrates the model's laws to fit..."
"A decade of speaking with traders and theorists has made me wonder what 'correct' means. If you are a theorist you must never forget that you are traveling through lawless roads where the local inhabitants don't respect your principles. The more I look at the conflict between markets and theories, the more that limitations of models in the financial and human world become apparent to me."
In summary, we know of no way to forecast either the size or duration of stock market trends (or trend reversals) that is reliable enough for successful market timing. Fundamentals (production, consumption, earnings, dividends, interest rates) matter, but lack of compelling theory keeps the forecasters chasing the data.
The stock market models on this site (currently projecting market behavior to the end of the third quarter of 2007) are modest attempts to mix some theory with a moderate amount of fairly recent fundamental data. The models fit empirical data OK, but not precisely.
The Reversion-to-Value Model is the simpler of the two. It assumes that the market P/E tends to revert to a mean calculated over a reasonably current period. This model's projection incorporates a current operating earnings forecast. This projection is therefore as sound as the earnings forecast and the concept of mean reversion. The earnings forecast is most unstable during periods of intense earnings release activity. This model shows that P/E reversion is generally a long-term and irregular process. For this model to "roll over," the operating earnings forecast would have to collapse.
The Real Earnings Yield Model is more theory-based. It assumes that investors require a return on investment (measured by the earnings yield, or earnings-price ratio) consistently above a "wealth discount rate" (measured by the inflation rate) and that this "real yield" tends to revert to a mean calculated over a reasonably current period. This model's projection incorporates a current operating earnings forecast and a current inflation rate forecast. The inflation forecast input sometimes varies substantially from month to month, and the model therefore displays considerable volatility. For this model to "roll over," the operating earnings forecast would have to collapse and/or (more likely) the inflation rate forecast would have to spike significantly.
Market timing is an elusive goal.
[Note that Dr. Hussman's relatively low stock market forecast accuracy grade derives from his weekly attempt to measure the quality of "market action," based on a combination of technical indicators, and not from his views about long-term mean reversion of financial ratios. He uses the "market action" measure to make short-term hedging adjustments.]
For related research, see Blog Synthesis: Gunning for the Fed Model? and Blog Synthesis: Some Trading Indicators.
