Vanguard: Fundamentals Useless for Predicting Stock Returns

Thursday, 21 Mar 2013 08:44 AM

By Michael Kling

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Fundamentals — corporate earnings, profit margins and gross domestic product (GDP) growth — are supposed to be the ultimate guide for judging stock values and predicting the stock market’s direction.

But those fundamentals are useless when it comes to forecasting stock market trends, a Vanguard study concludes.

“We’re not saying fundamental factors don’t matter,” Roger Aliaga-Diaz, a study co-author and Vanguard senior economist, told CNNMoney.

Video:
Economist Predicts 'Unthinkable' for 2013

The problem is that there are many other factors influencing stocks.

Vanguard economists examined the stock market going back to 1926 to reach their conclusion. Even the recent past shows the disconnection. Stocks jumped 16 percent last year, while corporate profits were up just 3 percent. European stocks surged 20 percent, while Europe was stuck a deep recession.

Earnings forecasts aren’t much help either, CNNMoney noted. Analysts are generally too optimistic, and their predictions are already priced into stocks anyway. Plus, they exhibit herd-like behavior, not wanting to be different from their forecasting peers.

Vanguard determined that the Shiller price-earnings (P/E) ratio, which uses average earnings over 10 years, is the best fundamental yardstick for predicting stocks, according to CNNMoney. That measurement currently predicts modest returns.

“We find that many commonly cited signals have had very weak and erratic correlations with actual subsequent returns, even at long investment horizons,” the report stated.

Poor measurements include trailing values for dividend yields and economic growth, the difference between the stock market’s earnings yield and Treasury bond yields (the so-called Fed Model), profit margins and past stock returns.

P/E ratios are better but even they explain changes in stock values only 40 percent of the time.

Other financial experts are aware of the disconnect between stocks and fundamentals like GDP growth.

A country’s GDP growth is different from its stock market outlook, Simon Hallett, chief investment officer at Harding Loevner, told The New York Times. “I cannot emphasize that enough.”

“If, at the beginning of 2012, you got a preview of all the headlines for the coming year, would you have believed the markets would be up this much?” Pat Dorsey, president of Sanibel Captiva Investment Advisers, told The Times.

Video: Economist Predicts 'Unthinkable' for 2013

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