by Ron Surz
The following formula works very well at explaining past performance, as well as making stock market predictions for future performance. It breaks returns into its components:
Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1
You can use this formula to forecast future stock market returns. Simply plug in your estimates of earnings growth and ending P/E. For example, the following table uses the formula to peer into 2015. The cell highlighted in yellow – earnings growth of 6% and an ending P/E of 15 – is the average long-term situation. In other words, if 2015 is “average” we’ll see a 19% loss next year. But what if it’s not average? The purple cells highlight a band around the average and indicate a performance range between a 10% gain and a 20% loss. By contrast, losses are not in most forecasts for 2015, so a 19% loss is a contrarian view.
We can also use the formula to look beyond 2015, to the end of the decade, as shown in the following table. Single digit returns are consistent with PIMCO’s “new normal.”
This framework can also be used for foreign markets, which are currently near historical averages, so their expected returns are near norm, namely returns near 9%.
Winners and Losers Forecast for 2015
In Searching for Alpha in Heat Maps, published in early April, 2013 I showed how heat maps could be used to profit from momentum effects. I then published my forecasts each quarter, and momentum effects “worked”, with winners continuing to win and losers continuing to lose.
So now I’ll offer stock market predictions for the first quarter of 2015 using heat maps. A heat map shows shades of green for “good,” which in this case is good performance relative to the total market. By contrast, shades of red are bad, indicating underperformance. Yellow is neutral.
The table below is the U.S. heat map for the year ending December 31, 2014. We see that the best performing market segments are mostly in the health care sector. Also, large cap value technology stocks have earned 28.4%. These would be the stocks to bet on if you want to make a momentum bet. Of course you could make a contrarion bet that these sectors will not do well. (See the Damon Runyon quote that begins this commentary.)
As for underperforming stock market segments, energy stocks are the place to look, plus large cap growth utilities-and-telephones.
Many quantitative managers employ momentum in their models, buying the “green” and selling the “red.” Fundamental managers use heat maps as clues to segments of the market that are worth exploring, for both momentum and reversal potential.
Moving outside the U.S., healthcare and consumer discretionary stocks in emerging markets have thrived with 40.1% and 35.2% returns, while energy stocks in all countries and styles have suffered.
To learn more about Ron Surz, visit him at www.TargetDateSolutions.com.
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