Predicting the future of the market is almost impossible, but that doesn't stop investors from trying. In his newest book, "Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years," James O'Shaughnessy argues that investors can predict where the markets are going by simply looking at historical long-term trends.

Through an examination of stock market history, O'Shaughnessy developed four stock selection approaches for individual investors that attempt to take maximum advantage of market trends. He focuses on finding stocks among the various market capitalizations that are most likely to do well based on his research.

O'Shaughnessy studied data dating back to the late 1790s and found that equity markets tend to move in trends of about 20 years. According to this pattern, a 20-year trend began in early 2000 during which greater returns will be earned by small- and mid-cap stocks and large-cap value stocks. The previous 20-year cycle favored large-cap growth stocks, while small- and mid-cap stocks and large-cap value stocks were, on average, underperforming the market.

The Philosophy

Although many investors believe that the market will return about 10% per year over the long-term, O'Shaughnessy gives a few reasons as to why the figure can be misleading. This number does not take inflation into account, which can eat away at returns and many investors fail to consider this when calculating portfolio performance.

O'Shaughnessy calculated the long-term inflation-adjusted average return to be about 7% per year and believes that the market will always revert to this mean. If the market has returned greater than 7% per year over several years, it will spend the next years regressing back toward the average, often overshooting this mark and falling below it.

Finally, O'Shaughnessy also argues that the average investor's holding period is 20 years as most people don't have the means to save for retirement until their prosperous middle years—about 20 years prior to retirement. The 10% long-term non-inflation-adjusted average return has typically been calculated over a 78-year period. Since most investors are not investing for 78 years, they are susceptible to the shorter-term ups and downs of the market, which tend to be much more volatile over 15- to 20-year periods.

Asset Allocation

Even when one group of stocks is out of favor, O'Shaughnessy still recommends investing in these stocks in order to remain diversified. He recommends 25% in micro-, small- and mid-cap stocks, and the remaining 75% in large-cap stocks for the conservative investor who wants to simply mimic the market's diversification. For the more aggressive investor, he recommends 35% in micro-, small- and mid-cap stocks, 50% in large-cap value stocks and 15% in large-cap growth stocks.

Portfolio Size

O'Shaughnessy recommends purchasing 25 stocks for a micro-, small- or mid-cap portfolio and 10 for a large-cap portfolio. Because small- and mid-cap stock are more volatile, additional stocks are needed to help diversify away some of the risks.

Large-Cap Stocks-Growth Market Leaders Screen

O'Shaughnessy looks for viable investments by combining growth and value constraints. This new Growth Market Leaders screen resembles both the Cornerstone Value and Cornerstone Growth screens he introduced in "What Works on Wall Street."

Company Size

First, O'Shaughnessy starts with the Market Leaders universe, a group of stocks he first introduced in the book "What Works on Wall Street." These stocks do not include foreign, utility and over-the-counter stocks.

The next Market Leaders criterion is asset size, which is the defining characteristic of these new screens. O'Shaughnessy categorizes large-cap stocks as those with market capitalizations greater than the average stock. He also looks for those with an average number of shares outstanding greater than the average stock.

Cash Flow Per Share

O'Shaughnessy's Market Leaders stocks also have higher cash flow per share than the average stock. This ratio is calculated by adding depreciation and amortization to income before extraordinary items, then dividing by the fully diluted average number of common shares outstanding. Cash flow measures the actual inflows and outflows of cash by taking out non-cash items that can boost net income (a number that is then used in earnings per share calculations). This is a harder number to manipulate and can be a more truthful measure of financial strength.

Sales

The final Market Leading criterion is stocks with overall sales that are 1.5 times greater than the average stock. O'Shaughnessy places emphasis on strong sales and a low price-to-sales ratio—the current stock price divided by the sales per share for the last four fiscal quarters (trailing 12 months). Unlike earnings, sales are less subject to management assumptions, therefore more difficult to manipulate, and are often less volatile.

The first additional criterion is a price-to-sales ratio less than the average for the Market Leaders. We can quantify this number by running a screen for Market Leading stocks, finding the average price-to-sales ratio for this group and inputting the value into the Growth Market Leaders screen. All viable companies have sales, so the majority of companies will have a meaningful price-to-sales ratio. A low price-to-sales ratio is a way to identify "cheap" stocks. In "What Works on Wall Street," O'Shaughnessy found that the price-to-sales ratio was a very effective screen for stocks of all market-cap sizes and that low ratios consistently produced higher returns.

Earnings

Earnings per share growth (revenues minus cost of sales, operating expenses and taxes, over a given period of time) is a popular way to measure a company's growth potential. Earnings per share play a critical role in a stock's price mainly due to market expectations. Low or negative earnings are often signs of young companies; however, these start-ups attempt to grow earnings quickly and can be profitable investments. The Growth Market Leaders screen finds stocks with earnings per share growth for the trailing 12 months that is greater than zero.

Relative Strength

Relative strength also plays a large role in a stock's price momentum. Relative strength measures how well a stock has performed versus a benchmark over a certain time frame. A negative number indicates underperformance while a positive number denotes a stock has performed better. O'Shaughnessy picks the top 10 stocks with the greatest 12-month price appreciation for his final portfolio. He found that stocks with the highest price changes over the past year tend to produce the highest returns the following year. Although this can be a very effective filter, he warns that it is a highly volatile approach. Stocks with high price appreciation may be at or close to their peaks meaning they may have smaller upside and larger downside potential. For this criteria, 52-week relative strength is adjusted until only 10 stocks pass.

Small-Cap Growth and Value Screen

O'Shaughnessy's Small-Cap Growth and Value screen focuses on small-cap stocks with upward price momentum using both growth and value criteria. The screen finds "cheap stocks on the mend."

Market Capitalization

The first criteria eliminate micro- and large-cap stocks by limiting the current market capitalization of passing companies to between $200 million and $2 billion. O'Shaughnessy adjusted these criteria limits for inflation using the long-term average rate of 3% per year. Adjusting for inflation is not only important for calculating portfolio returns. By adjusting the market capitalizations when backtesting and going forward, you are better able to maintain a database of desired cap-size stocks regardless of inflation's effect on asset size.

Price-to-Sales Ratio

A low price-to-sales ratio, as discussed earlier in the large-cap section, finds cheap stocks and provides a meaningful value for comparison and analysis. The Small-Cap Growth and Value screen specifies a price-to-sales ratio of less than 1.5.

Earnings Per Share Growth

Again, O'Shaughnessy wants stocks that have positive earnings per share growth over the trailing 12 months.

Relative Strength

Multiple price appreciation factors also help find companies that are growing earnings and whose stock prices are rising. This screen looks for stocks with above average 13- and 26-week relative strength. Finally, the field is further narrowed to the 25 stocks with the highest 52-week relative strength.

Tiny Titans Screen

For the more aggressive investor, the Tiny Titans screen searches for cheap micro-cap stocks with upward price momentum. O'Shaughnessy believes there are many advantages to investing in micro-cap stocks. Few analysts cover these small stocks and this lack of coverage leaves much room for upside potential when good stocks are largely unnoticed. Additionally, micro-cap stocks have a low correlation with other market capitalization strategies, including the S&P 500, which is comprised mainly of mid- and large-cap stocks. This means that the performance of the S&P 500 has a smaller impact on the performance of micro-cap stocks. For example, when the overall market (as measured by the S&P 500) is in a slump, a portfolio of micro-cap stocks is more likely to perform better. These tiny stocks, however, are highly volatile and best suited for investors who can handle the dramatic swings that a portfolio of these stocks will produce.

Market Capitalization

The Tiny Titans screen looks for stocks with a market capitalization between $25 and $250 million.

Price-to-Sales Ratio

The stocks must also have a price-to-sales ratio that is less than one.

Relative Strength

Finally, the 25 stocks with the greatest 52-week relative strength are picked for the portfolio.

All-Cap Value with a Growth Twist Screen

This last approach attempts to lessen the risk of small-cap stocks while still increasing a portfolio's overall diversification. It is a combination of both the Growth Market Leaders and Small Cap Growth and Value screens and adds a growth component to a mostly value-oriented screen.

Market Capitalization

Once again, O'Shaughnessy suggests using an inflation-adjusted market capitalization to narrow the field. Due to the volatility of micro-cap stocks, O'Shaughnessy wants to exclude them from this screen; however, it is capturing multiple capitalizations so there is no upward bound. The passing companies must have an inflation-adjusted (once again, using the 3% long-term average) market capitalization of greater than $200 million.

Price-to-Sales Ratio

Again, restricting the price-to-sales ratio eliminates stocks that are priced too high relative to company sales. This all-cap screen looks for stocks in the bottom three deciles based on price-to-sales ratio, or the 30% of stocks with the lowest price-to-sales ratio.

Price-to-Cash Flow Ratio

A low price-to-cash-flow element (calculated by dividing the current stock price by income before extraordinary items plus depreciation and amortization) also narrows the search to "cheaply" priced stocks. This ratio measures how much investors pay for a stock per dollar of a company's cash flows. It is similar to the price-to-sales ratio and the more familiar price-earnings ratio in that a low ratio indicates a cheaper stock. The lower the stock price compared to a company's cash flow, the lower the ratio will be. Once again, we are looking for the 30% of stocks with the lowest price-to-cash-flow ratio.

Dividend Yield

O'Shaughnessy also found that a high dividend yield (calculated by dividing the indicated dividend by the current stock price) was a useful criterion only for large-cap stocks. Companies that are new (which tend to be smaller companies) or are undergoing rapid growth will find better uses for excess cash, such as investing in the company's growth. Once a company matures, it may begin to pay dividends with excess cash. A high dividend yield indicates a low price compared to the stock's indicated dividend, meaning investors pay less per dollar of dividend. The final criterion finds the stocks in the top three deciles based on dividend yield, or the 30% of stocks with the highest dividend yield.

Relative Strength

The only growth element in this All-Cap screen is 52-week relative strength by selecting the 25 stocks with the greatest 52-week relative strength.

Actual Screen Performance

A link to a list of the screening criteria can be found in the right-hand column toward the top of the page, where a link to lists of the current passing companies of each screen can be found as well. The performance of these screens, which were backtested from January of 1998 through the present, can be seen by choosing Performance Chart. These portfolios are rebalanced monthly using equal dollar amounts in each stock. No transaction costs are taken into account.