Editor's Outlook

In this issue, Cara Scatizzi examines the investing principles outlined in James O’Shaughnessy’s latest book “Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years.”

O’Shaughnessy believes that one can predict the future direction of the market by examining long-term trends. Armed with this knowledge, he contends, you can select stocks to capitalize on the current trends. O’Shaughnessy examined over 200 years of data and found that the market moves in roughly 20-year cycles. Our feature article discusses where in the market cycle O’Shaughnessy believes we currently are as well as which market segments he believes will be most profitable over the remainder of the cycle.

In his previous book, O’Shaughnessy pointed to emotions and a lack of discipline as the main culprits for why investors are unable to beat the market. To overcome these issues, he presented his Cornerstone Value and Growth screens. Our feature article shows that his current research builds on his earlier work, but now focuses more on selecting stocks from among the various market-cap segments that are most likely to do well based on current market trends.

When viewing investment returns, O’Shaughnessy feels that most investors overlook the impact inflation can have on overall portfolio performance. Through his study of historical market trends, he has arrived at a long-term, inflation-adjusted average return of about 7% per year. While there will be years when the market exceeds this long-term average, and vice versa, he believes the market eventually reverts to this long-term average return. By examining the performance of the market-cap segments relative to this long-term, inflation-adjusted return, O’Shaughnessy tries to predict which segments are poised to outperform (or underperform) the others.

In O’Shaughnessy’s latest book, he outlines four different stock selection methodologies, each of which captures a different market-cap segment—large-cap, small-cap, and micro-cap, as well as an “all-cap” alternative. Each screen also combines elements of value and growth strategies. Our feature article focuses on O’Shaughnessy’s Small-Cap Growth and Value screen and shows how to replicate it using AAII’s Stock Investor Pro fundamental screening and research database program. The screening criteria for all four screens are provided here. To learn more about the methodology behind the other three new screens, as well as O’Shaughnessy’s earlier Cornerstone Growth and Value screens, please visit the AAII Stock Screens area of AAII.com.

O’Shaughnessy does not recommend investing only in the single market-cap segment favored by the current market cycle. Instead, he suggests building a portfolio of stocks from each market-cap segment in order to be properly diversified, thereby maximizing returns and minimizing risk. Depending on how aggressive you are, you can adjust your exposure to the various market-cap segments.

We hope you enjoy our feature article on O’Shaughnessy’s approach to predicting the markets of tomorrow.