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What Makes the Stock Market Tick?

There are thousands of really smart people whose job is to forecast where the stock market is heading.

I'm not talking about stock-pickers who focus on individual companies, but market strategists who try to predict where the Dow Jones (DJINDICES: ^DJI  ) and S&P 500 (SNPINDEX: ^GSPC  ) are going next.

And despite having more information than has ever been available before, here's the sad truth: We really have no idea what the market is going to do, even over 10-year periods.

Vanguard recently wrote a paper on how different variables impact future stock returns. It looked at popular metrics like P/E ratios, P/E ratios using the average of 10 years' earnings, dividend yields, GDP growth, profit margins, trailing market returns, and growth estimates to see how each has predicted future returns since 1928.

The answer is somewhere between a little and nothing:

Source: Vanguard.

Valuations are the single-best predictor of future returns, but they still only explain a minority of outcomes.

From there, it's dicey. Dividend yields tell you very little about future stock returns -- likely because the amount of earnings companies pay out as dividends fluctuates. GDP growth tells you virtually nothing. The same goes for earnings growth. Profit margins, trailing returns, and forecasts of earnings and GDP growth tell you nothing at all.

You'll notice that rainfall is one of the variables Vanguard included. That's exactly what it sounds like -- wet stuff falling from the sky. Of course, that should be a totally meaningless variable for predicting stock returns. But even that tells you more about future returns than analysts' projections of earnings growth. Rainfall!

Blogger Barry Ritholtz had a smart reaction to Vanguard's paper: "Perhaps a more significant complaint is a peeve of mine about single variable analysis -- that looking at any one metric alone to explain complex systems (such as investment outcomes) is doomed from the start."

In other words, Vanguard's analysis shouldn't be surprising at all. Anytime people try to make investing formulaic -- "I only buy when X variable is at Y" -- in a market that is influenced by billions of different variables, they are shooting in the dark. "Keep it in mind the next time you see someone trotted out on TV to claim that stocks are a great/terrible buy RIGHT NOW because of any single one variable," Ritholtz writes.

Instead, investors should form a mosaic of information that shapes their view of potential investments. Low valuations are a great starting point, but they don't guarantee happy results. What's the political climate? What are demographic trends? Will there be wars, oil shocks, natural disasters, technological breakthroughs, or banking panics? All of those will make some difference -- and, importantly, all are nearly impossible to predict.

The big takeaway for me is this: Most information we have at our disposal is useless to long-term investors, and even the important variables don't tell you the whole story. Investing isn't about certainties. It's about acting when the important variables (good companies and good prices) put the odds in your favor, possessing Zen-like patience, and accepting that, in the end, there's a chance things might not work out as planned. That's tough, but that's life.

Read/Post Comments (12) | Recommend This Article (31)

Comments from our Foolish Readers

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  • Report this Comment On November 28, 2012, at 10:01 AM, titus77 wrote:

    That's a lot of work to come to their conclusion:

    "This underscores a key principle in Vanguard’s approach to investing: The future is difficult to predict."

    And I thought the future was easy to predict!

    I'm not sure why the full article wasn't linked (so I'm not linking to it), but it is a good read and can be found pretty easily.

  • Report this Comment On November 28, 2012, at 11:13 AM, cooncreekcrawler wrote:

    Good article. If everyone took it to heart there would be a lot of "experts" looking for work. Come to think if it, that would not be a bad idea. Anybody want to rake my leaves?

  • Report this Comment On November 28, 2012, at 1:22 PM, Mathman6577 wrote:

    I don't know how the market will get there but over a really long period of time it tends to go up :)

  • Report this Comment On November 28, 2012, at 1:47 PM, TMFMorgan wrote:

    It was an oversight. Doesn't look like you had much problem finding it though.

  • Report this Comment On November 28, 2012, at 7:55 PM, benthalus wrote:

    I think a great follow-up article would be about patience itself (especially as it relates to investing), the multitude of influences in our society that make patience difficult, and how to counter those influences. Some of the same researchers who developed the ideas of biases in your previous article probably have some studies on patience.

  • Report this Comment On November 29, 2012, at 10:43 AM, Paulson545 wrote:

    Is it time to buy the Dogs of the DOW ? The out of favor stocks.The January Effect..T Boone Pickens bought 275,700 shares of Arch Coal and George Soros bought 4.4 million shares of Peabody Energy are these two Billionaires buying a few out of favor coal stocks because they feel a bottom has been put in ? jmho

  • Report this Comment On November 29, 2012, at 2:56 PM, SkepikI wrote:

    Morgan: A seminal article, among your best. Notwithstanding missing link (ha) thanks to Charlie!

    It is particularly fascinating to me as I am halfway through Silvers new book, and this goes straight to the heart of some of his theories. Paying too much attention to noise - poor information or even random bits masquerading as facts is likely the biggest mistake we "investors" make in this big casino in the sky. And yet it is NOT random chance at work totally. That would be easier- some of us would decide not to play... The multitude of variables make causation difficult if not impossible to discern. That kind of environment makes it imperative that you be selective on what decisions you make on where to invest and not just use rules that any fool can use (ha had to get it in)

  • Report this Comment On November 29, 2012, at 3:47 PM, JuampaF wrote:

    It really is impossible to predict the future, educated guesses is the best we can do. However, what I am really curious about is if the guys at vanguard tried plotting the variables against each other as well. Covariance can have really interesting effects on stuff, and it is important to bear in mind that also correlation is not causality. Data is pretty hard to interpret, but I would be very curious on doing an experiment with an MLR regression (multiple variables weighed in) and see if the correlation is better that way, although, if I had to guess, it would not be.

  • Report this Comment On November 30, 2012, at 1:06 AM, SkepikI wrote:

    The article by Vanguard is really worth reading, at least twice to get the full idea and to appreciate its flaws which are many. One is that their "fit" was linear and their figure of merit was R squared... this seems way too simplistic, but then so is single variable analysis. Their point however was NOT to try to achieve a correlation at all, just to simply and elegantly point out the failure of simple predictions. What really caught my eye though was just how "good" the correlation to P/E could be. Not great, but better than I would have presumed in a complex environment.

    Its also worth noting that Vanguard's purpose was to intro readers to THEIR probabilistic predictive approach and so flog their methods. Just something to consider as you mull this one over. I mulled it over while reading Nate Silver's chapter on the Stock market as an "efficient market"

    Its also interesting to contemplate how shares like Ruger can go for $4 each not so long ago. Same value proposition today, I think much different reception from the efficient market....

  • Report this Comment On December 03, 2012, at 11:38 AM, hbofbyu wrote:

    So no supercomputer can predict the stock market?

    Of course, because the individual behavior of millions of investors and how they will interact cannot be predicted. It doesn't keep people from making a career of it by trying.

    Billions of dollars and supercomputers now give me a 10 day forecast of the weather (that is often inaccurate) whereas 40 years ago we got a 5 day forecast that was just about as accurate. Improvements have been made, just not by much. If we can't get the weather right how is there any hope for the stock market?

  • Report this Comment On December 03, 2012, at 3:49 PM, Fabin81 wrote:

    If you buy a business that generates consistent profits, you will make a profit. haha. Now our job is to make our best bet as to which businesses those our. Or you can gamble, buy stocks without any business fundamentals and pray, like most of us do.

  • Report this Comment On February 17, 2013, at 7:51 PM, bugsnw wrote:

    That sent a warm, zen-like chill through me. I think we all felt this was true but no one dared say it.

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