Investing in the stock market is notoriously difficult to predict, yet many investors strive to anticipate where the market is headed. In his book Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years, renowned investor James O’Shaughnessy challenges conventional wisdom by suggesting that long-term market trends can be forecasted through historical data patterns and strategic stock selection.
In this article, we’ll explore O’Shaughnessy’s unique contrarian approach, his four key stock selection strategies, and how investors can use these insights to build diversified portfolios designed to outperform over the next two decades.
Most investors expect the stock market to deliver around a 10% annual return over the long term. However, O’Shaughnessy points out this figure can be misleading due to inflation, which erodes real returns. His research, spanning data back to the late 1790s, shows that the inflation-adjusted long-term average return is closer to 7% per year.
The key insight is that markets move in roughly 20-year cycles. When returns exceed this average for a period, the market eventually reverts toward the mean—sometimes overshooting on the downside. Given that the average investor’s holding period is about 20 years (often saving from middle age until retirement), understanding these cycles is critical to managing expectations and risk.
O’Shaughnessy’s analysis identifies a new 20-year trend that began around 2000. This cycle favors:
This contrasts with the previous 20-year cycle, which favored large-cap growth stocks while small- and mid-cap stocks and large-cap value stocks underperformed.
Even when certain market segments are out of favor, O’Shaughnessy advocates maintaining exposure to them to achieve diversification. His recommendations vary by investor risk tolerance:
This approach balances stability with potential for higher returns from smaller, more volatile companies.
To reduce risk, O’Shaughnessy suggests:
Smaller companies are generally more volatile, so a broader selection is required for adequate diversification.
O’Shaughnessy developed four screening approaches that blend growth, value, and momentum criteria to identify stocks likely to outperform:
This screen focuses on:
This combination targets large, financially strong companies with growth potential and favorable valuations.
Designed to find “cheap stocks on the mend,” this screen filters for:
For aggressive investors seeking high risk/high reward, this screen hunts for micro-cap stocks with momentum:
These micro-cap stocks often have less analyst coverage, offering untapped potential but significant volatility.
This hybrid screen aims to:
The approach balances value investing with a momentum growth component for better diversification and risk management.
O’Shaughnessy prefers these metrics because:
Relative strength measures how a stock has performed against the market over a period. Stocks with strong recent performance often continue to outperform in the near term. However, this can also mean they may be at peak prices, increasing downside risk if momentum reverses.
O’Shaughnessy’s screens have been backtested from 1998 to the present, showing consistent outperformance versus the market when portfolios are rebalanced monthly with equal dollar amounts in each stock. While transaction costs were excluded, the results highlight the power of combining value, growth, and momentum in stock selection.
James O’Shaughnessy’s Predicting the Markets of Tomorrow offers a compelling, data-driven contrarian investment strategy rooted in deep historical analysis. By recognizing long-term market cycles and employing systematic stock selection screens blending value, growth, and momentum factors, investors can position themselves to capture the returns favored by the coming 20-year market trend.
Whether you’re a conservative investor seeking diversification or an aggressive trader hunting high momentum small-caps, O’Shaughnessy’s approach provides a robust framework to navigate market volatility and build portfolios aligned with evolving market dynamics.
If you found this article insightful, feel free to share it with fellow investors or leave your thoughts below. What’s your take on contrarian investing? Have you tried any of O’Shaughnessy’s strategies? Let’s discuss!