What Do You Think the Market Will Do?

If you're like me, economists have a funny way of making your eyes glaze over. While they can be interesting, their forecasts of how the market is going to do are often so wrong it's laughable. So why do big banks like Citigroup (NYSE: C) hire droves of them?

I can't answer that one ...
While market forecasts will never find you big winners like eBay (Nasdaq: EBAY) or Infosys Technologies (Nasdaq: INFY) in their early stages, incredibly, investors keep listening to them. But besides filling airtime, reasonable market forecasts do have one good use: They are a great tool for keeping our emotions in check.

To know thyself is divine
If you are able to overcome your fear when everyone is selling, or shrug off the euphoria when everyone is making easy money, your returns will be immensely better than the herd's.

Of course, in an age of media echo chambers, this is not easy to do.

Where your forecast comes in
One way to maintain your objectivity during emotional times such as these is to have some rough expectation for what investing in stocks will do for you over the long haul. But how do you make a somewhat accurate forecast that is not just a shot in the dark?

In a recent speech to the Financial Planning Association, John Bogle, former CEO of Vanguard, noted that stock market returns are comprised of three factors:

• Dividend yield.
• Earnings growth.
• Speculative return.

So grab a sheet of paper and quiz yourself on how well you think the market is going to do over the next 10 years.

Dividend yield
Historically, most of the stock market's gains came from dividends. Companies like Kraft (NYSE: KFT) and Pfizer (NYSE: PFE) have long histories of putting tons of cash in the pockets of their investors. However, not every company is as generous, and in recent years fewer companies pay hefty dividends.

Many market forecasters will tell you the historical dividend return averaged 5%, but that's of little use when the current dividend yield is 2.9%. Jot down what you think is a reasonable average yield.

Earnings growth
Wall Street is obsessed with earnings growth, but they are terrible at making accurate predictions. Growth varies from racehorses like Intuitive Surgical (Nasdaq: ISRG) to turtles such as Altria (NYSE: MO), though in recent history corporate earnings growth has been 4.5%, down from about 6% over the past 25 years. With the U.S. economy growing around 2.7% annually over the past 10 years, reasonable corporate earnings growth estimates range somewhere between 2% and 10%. Whatever your estimate is, write it down.

Speculative return
Speculative return is the difference between the market P/E ratio now and what you expect it to be 10 years in the future.

The S&P's P/E has ranged from around 10 in the 1970s to over 40 during the tech bubble. Currently the market P/E ratio is 18, based on earnings from the past 12 months.

To find your speculative return, the difference between your prediction and the current P/E of 18 (adding if it's above and subtracting if it's below) is a good approximation. If you want to find the exact number, take the percentage change between the current P/E and the future P/E then multiply it by 10.

Ta-Da!!!
Add up your predictions for the three different numbers and you have your forecast for stock returns over the next 10 years.

To put your number in perspective, the average historical return for stocks is 9.6%. The guests at the aforementioned financial planners conference predicted stock returns of 7.2% over the next 10 years -- based on 2.3% dividend yield, 5.5% earnings growth, and an average P/E of 17. And Warren Buffett has indicated that he envisions market gains of 6%-7% over the next century.

Whether or not any of these predictions prove accurate, they provide a decent barometer of what your expectations should be and -- more importantly -- a reminder to continue investing even in turbulent times.

Now that you have an estimate of how you think the market will do, how well do you think you will do?

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Dan Dzombak admits he has a degree in economics, and that it hasn't helped him become a better investor. He holds no financial position in any of the companies mentioned in this article. Pfizer and Kraft Foods are Motley Fool Income Investor recommendations. Pfizer is also an Inside Value selection and Motley Fool holding. Intuitive Surgical is a Motley Fool Rule Breakers pick. eBay is a Motley Fool Stock Advisor recommendation. The Fool's disclosure policy was a philosophy major.