A. It's impossible for anyone to predict the stock market's short term moves. But how about long term returns in stocks and bonds? With historical data available and hard work, a small investor could try to make some reasonable predictions of future stocks and bonds' movements. We will introduce 3 methods below.
a. Use Shiller P/E
What is a Shiller P/E? It is a metric invented by Nobel laureate Professor Shiller for forecasting long-term returns. It is based on price/earning ratios, but considers the profit cycles a company experiences, so it compares current stock price to 10-year average earnings, after adjusting them to inflation.
The Shiller P/E will give you a fairly good idea about where the stock is headed, if you know the stock's historical average Shiller P/E's.
For example, overall the stock market's Shiller P/E has averaged about 17 since 1870. It is above 25 now. If you believe the reverse to mean rule, you can expect a below average future returns.
As expected, based on studies of historical data, it's found that your return will be higher when you invest at time of Shiller P/E is below average then Shiller P/E is above average.
In January 2000, S&P 500's Shiller P/E was 44, and between 2000 and 2015, its compound annual return was a subpar 4.1%!
In our next blog post, we will introduce the second method to predict future.