Customer Reviews

Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years

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In Predicting the Markets of Tomorrow author James O'Shaughnessy offers his ideas on the investment environment we are likely to encounter over the 20 years from 2006 through 2026. He selected twenty years as this time horizon based on extensive analysis of market behavior over approximately the last 200 years. His logic goes something like this:

1. When calculating returns from any investment strategy, it is essential to focus on the real return, after accounting for inflation.
2. Approximately two hundred years of stock market data (1809-2004) show that real returns have been highly erratic, especially when analyzed over periods of a few years or less.
3. However, when one calculates returns using overlapping periods of 20 years, they become much smoother. Stocks have rarely lost value over a 20 year period.
4. There are probably some underlying factors that cause returns to be smoother over 20 years. O'Shaughnessy suggests two. First, many investors don't really get started saving and investing until their mid 40s, giving than about 20 years to accumulate assets before retiring. Second, retirement at 65 together with a life expectancy of 85 suggests retirements (and asset depletion cycles) that last about 20 years.
5. If one decomposes the 20 year average returns of the S&P into the returns of the growth and the value stocks that comprise the S&P, these two groups have tended to move out of cycle with each other. Growth stocks occasionally have produced the higher return, as they did in the 1980s and 1990s. More often, value stocks have outperformed value stocks.
6. The returns of these three groups (S&P, Growth, and Value) all seem to revert to their mean rates of return. Any group that has outperformed in a 20 year interval is likely to underperform in the next 20 year period.
7. Since growth stocks outperformed in the 1980s and 90s, it's now their turn to underperform while value stocks outperform.
8. One can also segment the market by the capitalization (the total value of all the shares of a company). This analysis suggests that small cap stocks are likely to outperform large cap stocks over the next 20 years.
9. The average 20 year real returns /standard deviations of the key market groups between 1947 and 2004 have been:

Large Cap Growth: 6.26% / 3.83%
S&P 500: 7.30% / 3.76%
Large Cap Value: 10.32% / 3.42%
Small Cap: 10.42% / 2.94%

10. As seen in the figures above, Large Cap Value and Small Cap stocks have higher returns with lower standard deviations. When you add on the fact that these two groups have underperformed over the last 20 years, O'Shaughnessy appears to have a compelling argument for focusing on these two groups. To hedge his bets slightly, he recommends a preferred portfolio allocation of 50% large cap value, 35% small cap growth, and 15% large cap growth.
11. Fixed income securities, even inflation protected treasuries (TIPS) are currently producing returns that, at best, break even. They are "Return-free risks, not risk-free returns". Avoid them except as a place to park cash they you will need in the next few years.

Reviewer's Comments: I agree with O'Shaughnessy's approach and conclusions but would have liked a better justification for using 20 year average returns. One could argue that generations are separated by about 25 years which might make that figure the logical interval for averaging. Perhaps someone has (or should) compare the results of averaging over different periods such as 10, 15, 20, 25 and 30 years. Or, even better, use a Fast Fourier Transform to determine the power spectral density of each time series.

Not recommended. This allegedly "contrarian" book argues that the hot trends of the last 6 years (outperformance by small and value stocks) will continue for the next 20. I find any argument for the continuation of well-established trends inherently suspicious, but purchased this anyway to challenge my notion (based on other sources, mostly Morningstar) that large growth is attractively valued right now (even if French & Fama are right about small & value being best in the long run).

I didn't find much to challenge my view. The author's argument seems to be based entirely on reversion to mean, without any consideration of current valuations (P/E, Price/Book, Price/Sales) of the different market segments.

Two aspects raise the specter of data mining. First, the reversion analysis is based entirely on 20-year rolling data, but the grounds for picking 20 are thin. He says it's a typical holding period, but so are 10 and 25; I see no curiosity displayed whether the results would hold if different periods were used. Second, the stock picking rules laid out in Chapter 8, singled out for praise by another reviewer, give the appearance of having been selected from thousands of possible rules. I can't tell if these were previously published and have worked since then, but the backtesting is ALWAYS spectacular, and if enough rules were tried then the success of these was just random chance.

The author's portfolio recommendations are all domestic equity, and compared to a strawman historically bad allocation. Bonds are ultimately dismissed, although the chapter devoted to them contains some good information. REIT's, international investing, and commodities are skipped over in favor of advice to hire an advisor (which the author happens to be). The chapter on asset allocation should thus be called "My domestic stock picks," and contains no analysis of the benefits of rebalancing volatile asset classes. It's almost surely a mistake to own more than ~80% stocks, but you'd never know that from reading this book.

Another problem is the author's simultaneous praise at pp. 181 and 183-84 for the respective selection criteria of the Vanguard Value and Growth ETF's. The MSCI indexes (on which these funds are based) are just the flip sides of a coin. Of the 750 largest U.S. stocks, each index (and fund) contains only and exactly what the other does not. Thus if one is good, the other is bad. Ownership in both makes a simple cap-weighted index of the top 750 stocks (similar to S&P 500 funds, which the author elsewhere condemns).

In fairness, there is some good information on the tech boom and bust, demographics, and 401(k)'s. My bottom line, though, is that I got more out of both Richard Ferri's book on Asset Allocation, and William Bernstein's Four Pillars of Investing, even though it's out of date.

One final nit: IBM did not create the first laptop computer, in 1986, as stated on p. 242. That was Data General, in 1984.

I have read many investment books -- this is one of the best. It offers clear guidance and solid research to back up the predictions and claims. The claim that small-cap value stocks will outperform all the rest is backed by careful historical analysis and testing. I especially like the fact that the research done is for an appropriate time frame for those of us worried about retirement -- 20 years, and that "real returns" -- inflation-adjusted returns -- are used, instead of nominal returns that are most often cited by books and websites. The only hesitation I have in following the advice in this book is to invest in 10 large cap value stocks -- one of them, like GM, can easily go bankrupt and wipe out 10% of the portfolio value. I personally would stick to ETF, unless I have enough capital to hold at least 25 stocks in my portfolio. All in all, good, clear, and simple investment advice with serious research.

Chapter Eight of this book is worth the price of the book. The chapter is a simplified version of some of O'Shaughnessy's best strategies from his prior book, What Works on Wall Street. The book is a good introduction to the practice of investing. It lays out a strong case for using a disciplined process in choosing investments (rather than hunches). One's disciplined process should be backed up by historical data (not based on what's worked best in the most recent years or even decade). The six stock selection strategies featured in chapter 8, including the Dogs of the Dow, greatly peaked my interest. The only suggestion I have now is: James, get in touch with PowerShares to market ETF's for each of your featured stragies. I, for one, would buy them. Or create a mutual fund in which you implement your Custom Allocation (from page 212) on our behalf. This fund would weave together all six of your featured stategies. You convinced me that this is a powerful way to invest. Great book.

I wish I could have paged through this book before I got it. Based on the title, I was hoping that the book would discuss economic developments, new markets, new theories, or new technologies that would lead met to make better investments. Instead, I'd call this book more of a "technical analysis" piece. It's basic premise is that stocks move in 20 year cycles, and the cycle for large cap growth stocks ended in 2000. Therefore, put your money in small cap stocks and large cap value.

It's possible that some readers who invest in mutual funds will find this book useful, although they would have been better served had it been published in 2000. However, the book does not discuss, let alone even reference, techniques of analyzing individual stocks.

So what if many stocks got creamed in 2000? You didn't need to be a market historian to see that coming when p/e ratios and other indicia of valuation were so out of whack. Anyone following the value methodologies of Ben Graham ("Intelligent Investor") or Chris Browne ("Little Book of Value Investing") avoided getting slammed.

The book's basic premise is that by market timing specific sectors, individual investors can achieve outsized returns. I am skeptical that most investors will find this to be the case.

Even the title to this book is arguably misleading. The book is not truly contrarian - it's about interpreting historic market trends to predict the future. Anyone who has read a mutual fund prospectus can tell you that the SEC requires a statement to the effect that "past performance does not indicate future results" - readers would be well advised to keep that warning in mind.

If you want to read good books on contrarian investing, get David Dreman's "Contrarian Investing Strategies: the Next Generation," or one of the numerous books on behavioral finance that are available (example: Belsky & Gilovich's "Why Smart People Make Big Money Mistakes" or Paulos' "A Mathematician Plays the Stock Market.").

Sadly, I wish I had taken a pass on this book.

Citing copious historical statistics, James P. O'Shaughnessy argues persuasively that it is time for a new market orientation.

In his latest book Predicating the Markets of the Tomorrow, he says successful investors will abandon their love affair with large-cap growth stocks and mutual funds. Future performance will be dominated by small to medium sized growth companies and the large-cap value stocks, he says.

The first few years of this century have reacquainted investors with the concept that markets can and do fall. During the bear market that lasted from March, 2000 to March, 2003, the market darlings of the 1990s were crushed; the NASDAQ plunged 80 per cent; the S & P 500 more than 40 per cent. This time was not different. Evaluations do matter.

Drawing on more than a century of data, the originator of the "Dogs of the Dow" argues in the wake of that disaster, new market leadership, primarily small growth equities and large cap value stocks will supply the two decades of market leadership.

"The less a man knows," Sigmund Freud once wrote, "about the past and the present the more insecure must be his judgment of the future."

I have not read a better articulation of the market history than is found in this book. The past is the future's prologue. Over the long term markets revert to the mean. James P. O'Shaughnessy provides investors with a clear, concise and unemotional look at the market's history and a provocative glimpse into its future.

1. According to the OECD by 2030 the number of people over sixty five across the developed world will increase by 89 million, while the working adults will decrease by 34 million.

2. By 2026, India will be the third or fourth largest economy in the world with China close on its heels.

3. Two hundred years of financial data reveals the US markets have a strong tendency to revert to the mean. The last twenty years have offered investors outstanding returns, expansion of the PE ratio, and declines in dividend yields. Strong odds indicate the next twenty year cycle will face low expected returns.

4. 78 million Americans are approaching the traditional retirement age of sixty five. By 2018, Social security payroll taxes will no longer cover payouts, and the government will be forced to draw on the Social Security Trust fund surplus. Without changes in the social security payroll tax, shortfalls could reach $2 trillion by 2030. Reversion to the mean will impact Social Security, Medicare, and Medicaid over the next twenty years.

5. There are certain types of equities that will be the best performing asset classes over the next twenty years.

6. Baby boomers will realize they are responsible for their own retirements. They will flock to higher dividend stocks as a way to improve their portfolios. Large cap value stocks with higher dividend yields will move consistent with forecasts. Markets will favor small-cap stocks and large stocks with high dividend yields in the coming two decades.

7. Investing for long term weighting will return back to value investing. Short term emotional investing will occur as new emerging technologies come to market. When it does, large-cap growth stocks will soar in the short term. Short term performance will dismiss the long term forecasts of large cap value, for a time.

8. In purely rational marks investors price securities consistent with their true value.

9. There is an infinitesimal chance that large-cap growth stocks could outperform small-cap and large-cap value stocks.

10. The S&P index grew $1 to $22 from 1982 to 2000 or 19.4% per year. At the end of the 2000, everyone knew that large-cap growth stocks outperformed small-cap stocks and value stocks. Everyone wanted to be invested in high octane stocks. O'Shaughnessy said, "no other market mania has ever produced such outlandish valuations, and I believe that when the inevitable fall comes, it will be harder and faster than anything we have witnessed" and "near the top of any mania, you'll often see outright stupidity rewarded". Investors bought Red at $300 a share with outrageous PE ratios and Ebay with 10,000 PE ratios and Amazon. Qualcomm made instantaneous millionaires in one day, as stock prices shot upward, on China news.

11. J.M Barker said, "whenever you have a group of people thinking the same thing at the same time, you have one of the hardest emotional causes in the world to control."

12. For the first time in twenty years, investors have learn that valuation does matter and buying stocks on the whim and a hunch is the height of foolishness.

13. Small-cap stocks with much lower valuations and large stocks with high dividends and low PE's offered significantly between returns than the large-cap S&P 500 and the large-cap growth mutual funds.

14. Small capitalization growth are companies between $200 million and $2 billion; price to sales ratio is less than 1.5; earnings higher than the previous year; three and six month price appreciation is above average; buy 25 stocks with the best twelve month price appreciation; cheap stocks on the mend. The small-cap growth strategy has a excellent twenty year real rates of return, ranging from 7.8 to 18.6, percent per year with an average of 14.4 percent.

I love having numbers to back things up. I do. O'Shaugnessy delivers in spades. His opinions include some guesswork, but also thousands and thousands of checked inflation-adjusted returns from decades of the stock market, graphed nicely, so I can check his work and come to my own conclusions. I can imagine no better book on technical investing for me.

He also has good quick summaries of his findings at the end of each chapter and in the introduction, for the rest of you :-)

James P. O'Shaughnessy is a recognized authority on quantitative investing and something of a financial media star. In this accessible book, he offers an introduction to some seldom discussed facts of market life. We praise his well-documented introduction to market history, and his very lucid take on behavioral finance and the cognitive bad habits that lead so many investors astray. He notes that investors should avoid advisors who claim to be able to time the market or pick stocks. Instead, they should favor those who take the more quantitatively justifiable approach of stressing asset allocation. He does recommend rather strongly that investors should not attempt do-it-yourself plans, but rather rely on financial advisors - and being an advisor himself could conceivably have informed this opinion. Then, again, given his ace reporting on the pitfalls of bonds, big-cap growth stocks, American investing habits, historic patterns and bursting bubbles, who would want to go it alone?