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

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 :-)

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 produci

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.

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.