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This One Chart Shows Why Predicting Stock Market Moves Is Ridiculously Hard

Sam Ro
stock market returns decomposition

Vanguard Group

That purple line is ridiculous.

No one predicted that the S&P 500 would end 2013 up 30% for the year, closing at an all-time record high of 1,848.

As we entered 2013, Wall Street's stock market strategists had the tough task of forecasting what the S&P 500 would do after closing 2012 at 1,426, up 13% for the year and 114% from its March 2009 low.

The median year-end forecast for the S&P at the beginning of the year was 1,560, reflecting a modest 9% gain.

So, What Went Wrong?

Every stock market forecast ultimately comes down to two things: earnings and the valuation at which investors are willing to pay for them .

For the most part, strategists were spot on with their earnings forecasts. According to Bloomberg, strategists began the year looking for $107 in earnings for the S&P.  A year later, the S&P is on track to earn $110. That's a tiny margin of error.

So, it's pretty clear: everyone got the valuation wrong.

The chart to the right represents a decomposition of what drives total stock market returns. As you can see, earnings growth looks stable relative to the wild swings in valuation.

Valuation And Market Multiple Expansion

When stock prices outpace earnings growth like they did in 2013, experts say that the price-to-earnings (PE) multiple is expanding. Simply put, the stock market is getting more expensive. In other words, investors are paying an increasing premium for earnings.

In the long-run, this valuation measure tends to revert to a long-term mean.  But in the short run, however, they will trend for long periods of time, which means it spends a lot of time moving away from the mean. Another way of saying this is that a market that looks expensive will get much more expensive before becoming fairly priced again.

"Year to date, 75% of the S&P return has come from its PE expanding to 16.5x from 13.7x trailing EPS at 2012 end," wrote Deutsche Bank's David Bianco late last year. "Excluding 2009, this is the largest PE contribution to market return since 1998. "

This Is Always The Case

While valuations were a large part of 2013 returns, they've always played a pretty big role.

"In a simple return decomposition, this reversion has been the largest driver of the movement of long-term equity returns over time," said Vanguard's Joseph Davis, Roger Aliaga-Diaz, Charles Thomas, and Andrew Patterson. "This supports our long-held view that valuations, not growth, are the most significant drivers of returns."

Unfortunately, valuations are arguably the most difficult factor to forecast in the short-run. They reflect swings in sentiment and various psychological factors that play into investment decision-making, which rarely is very rational.

"But to what level will valuations revert?" asked Vanguard. "[M]ost valuation metrics have been above their long-term averages for more than two decades, raising questions about the potential for structural shifts. Without certainty as to where exactly valuations will move in the future, it is very difficult to pin down a precise estimate of the equity risk premium. This is a key reason for our distributional approach to forecasting."

Will valuations play a big role in 2014's returns? While most strategist agree that stocks will go up, they are totally split on whether the earnings multiple will expand or contract.

"Only the hubristic deign to project the market multiple," said Adam Parker, Morgan Stanley top U.S. equity strategist.

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