Introduction
Stock returns are not random but rather can be predicted with a measurable degree of confidence over the long term. While it may be difficult to predict stock returns over short periods of time, such as days, weeks, or quarters, the relative market return over longer periods, such as 5-10 year secular market cycles, is fairly predictable.
By using current readings of annualized inflation (CPI) and the P/E10 ratio (also known as the CAPE ratio), it is possible to identify consistent trends in long-term market returns. In addition, incorporating additional economic information in the form of the Economic Strength Index (the “ESI”) can significantly improve the accuracy of these forecasts when tested against historical data, increasing their statistical confidence.
Methodology
The above forecasts were obtained by inputting three main economic data series into a Gradient Boosting machine learning model and applying various feature engineering techniques before forecasting for each time period. The data series used are:
P/E10 Ratio
The P/E10 ratio, also known as the cyclically adjusted price-to-earnings ratio or the CAPE ratio, is a valuation measure developed by economist Robert Shiller that uses real per-share earnings over a 10-year period to evaluate the relative value of a stock or the overall market. It is calculated by dividing the price of the market by the average of its inflation-adjusted earnings over the previous 10 years.
The P/E10 ratio is a valuable tool for this website's forecasts because it is used as a long-term measure of relative valuation. It smooths out the effects of short-term fluctuations in earnings and reflects the overall profitability of the market over a longer time frame than many other commonly available valuation metrics. The P/E10 ratio is often used to compare the relative valuations of the market during differing time periods or to assess whether a particular market is overvalued or undervalued.
CPI Inflation
CPI inflation, or consumer price inflation, is the rate at which the general level of prices for goods and services is rising, resulting in a decline in purchasing power. This indicator is important for the overall health of the economy and is closely watched by central banks, which use monetary policy tools to influence the level of inflation.
Inflation, as measured by the Consumer Price Index (CPI), can have a significant effect on stock valuations and prices, as it influences the discount rate investors use to evaluate equity investments. When inflation is high, it can reduce the value of a company's earnings, resulting in a decline in stock prices as investors require a higher return to offset the decline in purchasing power. Conversely, low inflation can make a company's earnings appear more valuable and lead to an increase in its stock price as the required return for investing in equities decreases. By understanding the discount rate investors will expect to require for investing in equities, we can use the current CPI to estimate the future value of stock returns and gauge the relative demand for equities at any given point in time.
Valuation Heatmap
The following heatmap chart allows investors to visualize the relationship between stock market valuations (P/E10 ratio) and inflation, with the P/E10 ratio plotted on the X-axis and inflation plotted on the Y-axis, and how these variables can affect expected market returns over the following 10-year period.
It shows that periods of high inflation tend to compress P/E ratios, leading to lower stock valuations, while periods of low inflation tend to expand P/E multiples, resulting in higher stock valuations. With this chart, investors can compare different return profiles based on present levels of inflation and market valuation and make informed decisions based on historical data.
The Economic Strength Index
The accuracy of the foregoing forecasts are significantly strengthened by the addition of the Economic Strength Index (the "ESI") into our model. The ESI is an economic indicator developed by William Gorfein to assess the overall activity of the US economy. It provides a snapshot of the health and strength of the economy, reflecting whether it is expanding or contracting, at any given point in time.
The ESI is calculated by analyzing a range of indicators, including automotive, employment, housing, stock and bond market, and banking data, to gauge the momentum of the economy. It is a valuable tool for understanding the current state of the economy and for forecasting future economic conditions, including the likelihood of an upcoming recession or the possibility of entering or leaving a recession.
The chart below compares the r^2 values of the forecasts with and without the inclusion of the ESI. The inclusion of the ESI leads to a significant improvement in the forecasting ability of the model, suggesting that taking into account current economic data enhances the ability to predict stock market returns over the long run. This aligns with the common understanding that the stock market, as a reflection of investor confidence in the overall economy, serves as a gauge of economic health and future stock market performance.
Created By
William Gorfein © All rights reserved
https://williamgorfein.com
