At the beginning of every year, market commentators and analysts give their predictions on where the market will close. Research has shown that most of these forecasts did not perform significantly different than a chance forecast. In other words, similar to a coin flip. Stocks have returned about 10% nominally annually post WWII. So, the safest bet is to close your eyes and predict 10% every year. The question is, why do so many intelligent and informed analysts get it wrong?

The answer lies in the composition of stock market returns. There are 3 components: Dividends, Earnings, and Change in PE. The first two can be quantified and thus predicted reasonably well. However, the 3rd and final piece of the puzzle is completely based on sentiment. Of which, no one can predict with any consistency.

1. Dividends

(Click on image to enlarge)

The dividend yield on the S&P 500 is calculated by taking the dividend per share of all companies in the index, divided by the price of the S&P 500. The chart above shows the current dividend yield on the S&P 500 is 1.80%. Dividend yields rise as stocks fall, and vice versa. So there are positive aspects to market declines.

2. Earnings Yield

The earnings yield is calculated by taking the earnings per share of all S&P 500 companies and dividing it by the price of the index. Like Dividend yields, earnings yield increase as price declines, and vice versa.

Currently, the projected earnings per share for S&P 500 companies over the next year is $173.61. The S&P 500 is currently trading at 2837 as I type this. Therefore the earnings yield is currently 6.12%. Which is attractive given that treasury bonds still only yield 3.22%.

3. Change in PE (Price-to-Earnings ratio)

So if we have a dividend yield of 1.80% and an earnings yield of 6.12%, doesn’t that mean we should expect an annual return of 7.92%? Oh if things were that simple!

There’s a 3rd component, the change in PE ratio. This has to do with how much investors are willing to pay for those earnings. Generally, when things are going well, investors will pay above average “multiples” of earnings. But in the short term, there isn’t a reliable way to predict how investors will react.

Recent examples are Oil and Interest rates. Oil fell from $100 to $25 back in 2015, first the narrative was falling oil was great for consumers, then it shifted to falling oil being deflationary and a precursor to recession/bear market. The sentiment has shifted on the way up as well.

Investors have been nervous as the yield curve has flattened, now that interest rates are rising (yield curve widening) it appears nervousness has reemerged. These narratives may or may not have anything to do with the actual price movement. My point is that shifts in sentiment (whether it be fundamentally sound or not) can and will fluctuate rapidly from one year to the next.

If you’re an investor, it’s best to stick with the fundamental data and take advantage of the opportunities the market gives you. You can predict a market driving event right, but still miss how investors will react to that outcome. It’s best to stay diversified, stick to your plan, and take advantage of those opportunities.