Can you predict the stock market? What are some things you should look out for before buying a stock?<\/p>\n\n\n\n
It\u2019s difficult to make more money<\/a> than an average investor in the market. This is because everyone is working with the same information. However, if you know how to predict stock market performance, you can make above-average gains. <\/p>\n\n\n\n In this article, you\u2019ll learn what to look for when trying to gauge what\u2019s going to happen in the stock market as a whole as well as with individual stocks. <\/p>\n\n\n\n\n\n\n\n The stock market is a nearly random walk that trends upwards. Generally, as the world economy continues to grow, more people will put their money into the market. This leads to an upwards trend. It\u2019s nearly<\/em> random because people who are well informed about market conditions can, on aggregate, make a little bit more money than the average investor. <\/p>\n\n\n\n With this in mind, the first step in learning how to predict stock market performance is to understand how different market conditions affect stock prices. In his book A Random Walk Down Wall Street<\/em><\/a>, academic economist and former Wall Street portfolio manager Burton Malkiel discusses how prevailing market conditions have historically affected the stock market during the key periods from the 20th century onwards.<\/p>\n\n\n\n The post-WWII period was an advantageous time to be invested in common stocks, less so in bonds. Due in large part to Kennedy\u2019s tax cut in the early \u201860s and government spending<\/a> to finance the war in Vietnam, employment was high and consumer spending considerable. By 1968, P\/Es were north of 18, and stocks were returning 14% annually on average<\/strong>.<\/p>\n\n\n\n However, bonds did not fare nearly as well, posting an average annual return of 1.8%<\/strong> during the period (returns including inflation were actually negative <\/em>for the period). The main factors contributing to bonds\u2019 poor performance were low<\/strong> initial<\/em><\/strong> interest rates<\/strong>\u2014the government had pegged government bonds\u2019 interest rates at a maximum of 2.5% to finance WWII cheaply\u2014and rising interest rates as the years wore on.<\/p>\n\n\n\n The financial story of the period between 1969 and 1981 is all about inflation<\/strong>. A concatenation of events\u2014increased demand caused by the Vietnam War<\/a> stimulus and oil and food shocks in the mid-1970s\u2014resulted in an inflation rate of 6.5% by the end of the 70s. By 1981, inflation had risen to double digits<\/strong>, forcing US Fed Chairman Paul Volcker to raise interest rates significantly. Unfortunately, inflation didn\u2019t immediately slow down, and unemployment spiked (so-called \u201cstagflation\u201d\u2014inflation combined with a stagnating economy).<\/p>\n\n\n\n Returns on stocks and bonds suffered mightily from these tough economic conditions. Although the average annual return on stocks was 5.6% for the period, returns were negative after factoring in inflation<\/strong>. Bonds suffered even worse: Yields in 1969 anticipated a 3% inflation rate; with inflation nearing 8%, returns were utterly wiped out.<\/p>\n\n\n\n Careful readers will wonder: If stocks are supposed to be an inflation hedge, why did they also underperform during this period? The answer lies not in falling earnings or dividends\u2014which, the evidence shows, remained robust\u2014but rather in stocks\u2019 P\/E multiples. Simply put, investors were scared\u2014they weren\u2019t willing to pay a premium for solid earnings and dividend growth. Thus stock prices dropped precipitously, slashing returns.<\/p>\n\n\n\n Considered by Malkiel to be the golden age of asset returns, this era found stock and bond prices adjusting to the inflationary environment and offering attractive returns. <\/p>\n\n\n\n In bonds, average annual rates of return over the period were around 13.6%, a very attractive number. One reason returns were so high was high initial yields (approximately 13%). Because inflation was high at the outset of the period (around 8%) and investors were wary after the bond market catastrophe in the previous period, issuers had <\/em>to offer high yields to attract investment. When interest rates fell and inflation moderated over the course of the period, bondholders reaped the benefits.<\/p>\n\n\n\n In stocks, average annual rates of return over the period were even better at 18.3%. Again, the poor returns of the previous period created a pessimistic environment wherein assets were undervalued. In 1982, P\/E multiples were 8, signaling investor skepticism about companies\u2019 prospects for solid future growth. However, by 2000, P\/E multiples had nearly quadrupled to 30. This new investor optimism raised returns to unprecedented heights.<\/p>\n\n\n\n If 1982\u2013early 2000 the high for investors, 2000\u20132009 was the comedown.<\/p>\n\n\n\n During this period, often referred to as \u201cthe lost decade,\u201d average annual returns for stocks were woeful: \u20136.5%. First there was the bursting of the dot-com bubble, which saw P\/E multiples plummet. Then there was the 2008 financial crisis\u2014caused by another bubble, this time in housing\u2014which caused stock prices to decline even further.<\/p>\n\n\n\n One of the few bright spots during this spell was the bond market. Bonds posted an average annual return of 6.4%, offsetting some of the pain of stocks (if you were diversified enough to have bonds in your portfolio).<\/p>\n\n\n\n As was the case in 1982, 2009 offered the kind of pessimistic conditions that could\u2014and did\u2014lead to windfall returns. This historical stock market return example shows how returns work in response to a crisis.<\/p>\n\n\n\n During this period, as the economy recovered from the financial crisis, earnings grew by double digits and P\/E multiples rose as well, resulting in an average annual return on stocks of 17.5% (just a point behind the golden age of 1982\u20132000).<\/p>\n\n\n\n Bond returns during this period, though far less sensational than stocks, were still positive at 3.8%. <\/p>\n\n\n\n The above list of historical stock market returns<\/a> will help you understand what factors contribute to annual rates of stock market return.<\/p>\n\n\n\n \nTITLE: A Random Walk Down Wall Street<\/a> Economists are hired by investment firms or individuals because they\u2019re generally right about the market\u2019s direction more often than they\u2019re wrong. They know how to predict stock market performance because they understand the future of markets better than the average person. <\/p>\n\n\n\n But what about individual stocks? How do you predict what happens to the share price of a certain company? Is it possible to predict stock performance, in principle? <\/p>\n\n\n\n In his book The Simple Path to Wealth<\/em><\/a>, blogger and financial expert JL Collins writes that investors should beware of the temptation to try and predict stock performance, or to believe an analyst who says he can.<\/p>\n\n\n\n Analysts study industry sectors and companies to try to predict stock performance. But their predictions aren\u2019t typically accurate because they\u2019re based on companies\u2019 own internal performance forecasts (sales predictions), which are guesses. Further, these guesses are often inflated by managers and CEOs so they look better for Wall Street.<\/p>\n\n\n\n As Collins points out, <\/strong>no one knows how to predict stock market performance nor how to pick winning stocks from reading company reports and analyses. <\/strong>Nor can you do so by reading books on valuing stocks like The Intelligent Investor<\/em><\/a>, which was written by Warren Buffett\u2019s mentor in 1949, when there weren\u2019t many managed mutual funds available (so if you wanted to invest, you had to pick stocks). If you\u2019re interested in stocks analysis, the book is worth reading, but it won\u2019t teach you how to predict stock market performance or pick winning stocks. <\/p>\n\n\n\n \nTITLE: The Simple Path to Wealth Similar to Collins, Tim Harford (The Undercover Economist<\/em><\/a>) asserts that trying to learn how to predict stock market performance or to anticipate the share price of individual stocks based on company reports and analyses is futile. <\/p>\n\n\n\n According to Harford, <\/strong>stock prices are the representation of what the market thinks <\/em>a company will earn in the future. Investors and economists are attempting to judge not the current profitability of a company, but what the current numbers and the state of the economy mean for a company\u2019s <\/strong>future <\/em><\/strong>profitability. <\/strong><\/p>\n\n\n\n When you buy a stock, you\u2019re buying a small part of the company. Theoretically, as a shareholder, you get back part of a company\u2019s profits. In practice, though, shares are more about prospects <\/em>than profits. <\/em>When a company makes a profit, it generally reinvests that money into growing its business. Companies spend money on development of a new product or advertising of an existing one. As a shareholder in a company, you\u2019re betting that they\u2019ll have more success with their reinvestments and general growth than the market assumes. <\/p>\n\n\n\n The stock market, then, is less about companies\u2019 fundamentals and more about what other people think of a company. <\/strong>To illustrate this principle, Harford brings up the following example. Two English investors once got into a discussion about the stock price of Grolsch beer. Grolsch had taken off in London, and it was served at every major pub in the city. Grolsch hadn\u2019t found the same foothold in the rest of the country. However, a lot of big investors in England live in London. And many of the investors who live in London assumed, incorrectly, that Grolsch beer is popular everywhere. Thus, these investors thought that Grolsch stock was undervalued, bought a lot of the stock, and drove the price up. <\/p>\n\n\n\n Even if you know <\/em>that Grolsch isn\u2019t popular in the rest of the country, if you realize that London\u2019s investors are about to buy a large quantity of Grolsch stock, you can get in at a lower price and make a lot of money. The fundamentals of the business catch up with the stock eventually. If Grolsch\u2019s quarterly reports don\u2019t show the growth that investors expect, they might start to sell off. But if you\u2019re playing the stock market, buying and selling companies fairly frequently, the fundamentals of a company don\u2019t matter nearly as much as what other investors think about the quality of a company. <\/p>\n\n\n\n As the above example showed, when playing the market it\u2019s generally safest to run with the crowd. <\/strong>If a lot of people think a company is going to be successful, buy stock in it, because the stock price is likely to go up. <\/p>\n\n\n\n However, sometimes the crowd can get an entire industry wrong. The dot com bubble<\/a> of the early 2000s happened because investors started investing a lot of money in every internet company, no matter how unsuccessful they looked. At the height of the bubble, the market was pricing internet companies as if they would grow more quickly in the future than any group of companies ever. <\/em><\/p>\n\n\n\n Some technology companies, like Microsoft, did have good fundamentals and withstood the bubble better than many. But lots of internet companies didn\u2019t have a clear growth plan, and so, after they couldn\u2019t report growth, came crashing back down to earth. Investors ran with the crowd upwards until the argument for historic growth became untenable. <\/strong>Then, they ran with the crowd on the way down. This sort of groupthink<\/a> can lead to wild swings in the market. <\/p>\n\n\n\n In addition to the crowd\u2019s sentiment, it\u2019s also important to look at the ratio of the price of the stock to the earnings of a company. Historically, the total price-to-earnings ratio has hung around 16 to one. <\/p>\n\n\n\n Before making a long-term investment in a company, always take a look at the company\u2019s fundamentals. But in particular, if the company\u2019s stock price is more than 16 times greater than its earnings, take an even closer look. This means that the market thinks the company will grow quickly. <\/em>It also means that it\u2019s due for a crash. Again, in the dot com bubble, the total price-to-earnings ratio of internet companies skyrocketed past 16 to one. <\/p>\n\n\n\n \nTITLE: The Undercover Economist<\/a> No one knows how to predict stock market performance with 100% certainty. That said, you can anticipate<\/em> what\u2019s going to happen if you\u2019re well-informed about the market conditions. As for individual stock prices, it\u2019s safest to run with the crowd (do people think the company\u2019s share price will go up or down?). Finally, make sure to examine the company\u2019s price-to-earnings ratio: If it\u2019s greater than 16, that company may be due for a crash.\u00a0<\/p>\n\n\n\n If you enjoyed our article about how to predict stock market performance, here are some suggestions for further reading: <\/em><\/p>\n\n\n\n Fooled by Randomness<\/em><\/strong><\/a><\/p>\n\n\n\n In Fooled by Randomness<\/a><\/em>, former options trader Nassim Nicholas Taleb<\/a> examines the outsized role luck plays<\/a> in success, how and why people don\u2019t generally understand luck, and how we can accommodate randomness in our lives once we\u2019re aware of it. Taleb primarily focuses on examples from the world of investing, but his principles are applicable to any field ruled by unpredictability (such as economics or politics) and demonstrate how we\u2019re fooled by randomness in many aspects of our lives.<\/p>\n","protected":false},"excerpt":{"rendered":" Can you predict the stock market? What are some things you should look out for before buying a stock? It\u2019s difficult to make more money than an average investor in the market. This is because everyone is working with the same information. However, if you know how to predict stock market performance, you can make above-average gains. In this article, you\u2019ll learn what to look for when trying to gauge what\u2019s going to happen in the stock market as a whole as well as with individual stocks. <\/p>\n","protected":false},"author":7,"featured_media":47479,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[81,31],"tags":[452],"class_list":["post-91790","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-economics","category-money","tag-guides","","tg-column-two"],"yoast_head":"\nHow Market Conditions Affect Stock Market Returns<\/strong><\/h2>\n\n\n\n
Period I: 1947\u20131968<\/strong><\/h3>\n\n\n\n
Period II: 1969\u20131981<\/strong><\/h3>\n\n\n\n
Period III: 1982\u2013early 2000<\/strong><\/h3>\n\n\n\n
Period IV: 2000\u20132009<\/strong><\/h3>\n\n\n\n
Period V: 2009\u20132018<\/strong><\/h3>\n\n\n\n
\nAUTHOR: Burton G. Malkiel
\nTIME: 61
\nREADS: 212.3
\nIMG_URL: https:\/\/www.shortform.com\/blog\/wp-content\/uploads\/2020\/11\/a-random-walk-down-wall-street-cover.png
\nBOOK_SUMMARYURL: a-random-walk-down-wall-street-summary-burton-g-malkiel
\nAMZN_ID: XYZ
\n<\/p>\n\n\n\nPredicting the Performance of Individual Stocks<\/strong><\/h2>\n\n\n\n
\nAUTHOR: JL Collins
\nTIME: 30
\nREADS: 98.9
\nIMG_URL: https:\/\/www.shortform.com\/blog\/wp-content\/uploads\/2020\/11\/the-simple-path-to-wealth-cover.png
\nBOOK_SUMMARYURL: the-simple-path-to-wealth-summary-jl-collins
\nAMZN_ID: XYZ
\n<\/p>\n\n\n\nRunning With the Crowd<\/strong><\/h3>\n\n\n\n
Price\/Earnings Ratio<\/strong><\/h3>\n\n\n\n
\nAUTHOR: Tim Harford
\nTIME: 40
\nREADS: 87.7
\nIMG_URL: https:\/\/www.shortform.com\/blog\/wp-content\/uploads\/2021\/05\/the-undercover-economist-cover.png
\nBOOK_SUMMARYURL: the-undercover-economist-summary-tim-harford
\nAMZN_ID: XYZ
\n<\/p>\n\n\n\nFinal Words<\/strong><\/h2>\n\n\n\n