Thursday, 4 July 2013

Predicting the Stock Market

By Christopher W. Mayer (July 2001)

As the nation's equity markets crumbled, the question that inevitably arose was "When will stock prices stop falling?" And there was always some willing economist, journalist, politician, or other self-appointed pundit ready to take the bait.

Jeremy Siegel is one such prominent economist. Siegel is famous among stock market followers for his best-selling book, Stocks for the Long Run, which has run several editions. The book tracks equity returns going all the way back to 1802. The general premise is that stocks are the best long-term investments one can make.

In a piece that appeared in Knowledge@Wharton, titled "When will stock prices stop falling?" Siegel argued that the historical twentieth-century price-earnings ratio of the average stock in the S&P 500 was outdated and no longer valid. The historical average is about 15 compared with the current average of about 24 (well below the April 1999 peak of 36).

Siegel noted that the century-long average of 15 included such events as the Great Depression, other prolonged recessions, periods of world war, double-digit inflation, and high interest rates. As a result, Siegel makes this stunning conclusion: "You have to take out some of these real bad events. I don't think they're going to happen again, because we know how to avoid those."

Granting for the moment that such long_run historical averages are even relevant, the whole point of using an average is to have some measure of central tendency and compensate for the dispersion of data. If Siegel wants to eliminate all the bad events of the century, then perhaps we should also take out some of the really good periods too, like the run-up of the 1920s that took us to the 1929 peak. Maybe we should also eliminate the bull market of the 1950s and `60s. Maybe we should also eliminate the greatest of all bull markets, the run-up in stock prices during the 1990s.

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