Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years
Summary
O'Shaughnessy, who wrote What Works on Wall Street, argues in this book that large-capitalisation growth stocks would underperform over the following two decades and that investors should hold small and mid-capitalisation value and dividend-paying stocks and real assets instead.
His method is the same as in his earlier work: examine long-run historical return data by factor and by capitalisation, identify the periods when each performed and the valuation conditions at the start of those periods, and argue that starting valuations determine subsequent returns. His argument in 2006 was that large growth stocks had entered the period at valuations that historically preceded poor returns, that the demographic and monetary conditions favoured other categories, and that investors extrapolating the prior two decades would be positioned wrongly.
The forecast was partly right and substantially wrong on timing and duration. Small and mid-cap value did outperform for a period, and then large-capitalisation growth produced an extended run of returns that the historical relationships did not anticipate, driven by a small number of technology companies whose economics differ from anything in the historical dataset.
The reference has not verified the specific data and projections in this book. Its value is as a demonstration of the method's limitation: factor-based historical relationships are the best available evidence about long-run returns and they do not bind, and a period long enough to matter to an investor's life can run against them.
Key takeaways 7
- Starting valuations by capitalisation and by style are the best available predictor of subsequent long-horizon returns.
- Investors extrapolate the prior two decades into the next, which is why the categories that performed best are the ones priced worst.
- Small and mid-capitalisation value and dividend-paying stocks were argued in 2006 to be positioned better than large growth for the following twenty years.
- Historical factor relationships are the best available evidence about long-run returns and they do not bind over any period short enough to matter to an investor.
- An extended period of large-capitalisation growth outperformance followed publication, driven by companies whose economics have no precedent in the historical data.
- A correct method applied to correct historical data can produce a forecast that fails, which is a limitation of the approach rather than an error in it.
- The reference has not verified the specific data and projections in this book.
Who should read it
Investors interested in factor-based long-horizon forecasting and in a documented case of the method producing a forecast that did not hold.
About James P. O'Shaughnessy
Founder of O'Shaughnessy Asset Management and of O'Shaughnessy Ventures; hosts the Infinite Loops podcast.
What Works on Wall Street tested valuation, growth, momentum and quality factors against decades of Compustat data and published the return series for each, which set the expectation that a strategy is argued from out-of-sample evidence rather than from reasoning alone. The composite value and shareholder-yield screens it describes became standard practice in quantitative equity.
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