forecast

By Roger L. Geweke, CFA, Clifford Swan Investment Counsel

As the calendar turns to each new year, it is common for the news media to recap important events in the last year and elicit expert predictions about what will happen in the year to come. At this point in a market outlook, the author is expected to predict what will happen in one or more tricky investment areas and suggest a course of action that would logically follow from that prediction to produce outsized investment profits.

It is logical to assume that to do well as an investor it is necessary to make accurate forecasts about the near-term future of the economy, interest rates, the stock market, the industries that should profit most, and the companies within those industries which have the brightest prospects. After all, the experts that appear on television to provide their forecasts have no problem sharing their investment insights. They are well-dressed, experienced, articulate, and speak with an air of authority—but do they really add anything of value to investors?

Studies of economic and stock market forecasts have shown that those forecasts generally assume recent trends will continue indefinitely into the future; as such, they are destined to be incorrect at the most important point: when a trend reverses course.

In January of each year, Barron’s, a well-respected weekly financial publication, convenes eleven well-known investors and financial forecasters for their Roundtable, where they give their insights and predictions in a series spanning three issues of the magazine. In the January 12, 2009 edition, general skepticism about the economy, the stock market, and the future of the financial system abounded. The S&P 500 had already dropped over 40% from its high in October 2007. As evidence of the fear surrounding the prospects for stocks at that time, none of Barron’s participants were willing to predict that the stock market would return over 7% either in 2009 or on an annual basis over the next five years. This is despite the fact that the stock market had a compound annual growth rate of 9.5% for the eighty-four years preceding 2009, a period that included the Great Depression, World War II, the Korean War, the Vietnam War, the Gulf War, the stagflation and record-high interest rates of the 1970s and 1980s, and the bursting of the Internet bubble in the early 2000s. None of the forecasters were willing to predict even average returns for the market for the foreseeable future. What happened next? Less than two months later the market bottomed and stock market investors enjoyed returns of 26% in 2009 and 17% per year for the next five years, with only 2011 showing a return less than that predicted by the most optimistic of the Barron’s forecasters.

Maybe the stock market and economy are hard to predict, but surely the knowledgeable Wall Street analysts who follow only a few companies would be able to utilize their deep industry knowledge to make accurate earnings estimates, wouldn’t they? In a study by David Dreman, from 1973-2010 (a period that encompassed over 800,000 quarterly earnings estimates) the average analyst estimate missed subsequently reported earnings by an average of 40%. One might think analysts would do better over time thanks to the Internet and the recent explosion of information, and they did—over the last 15 years of the study they only missed by an average of 35%. This is not nearly well enough to argue for investing your money in a manner that relies on earnings forecasts.

In defense of professional analysts and investors, much more can happen to render a forecast obsolete than anyone can anticipate, which is precisely the point of this article. Forecasting the future is extremely difficult, if not impossible. Keep that in mind when you watch the news and someone is forecasting the price of oil, the stock market, interest rates, or the economy!

Have we broken the prediction addic-tion yet? If so, what do we do instead?

First and foremost, it is important for an investor to understand themselves and their own individual financial situation. Only then can one formulate an appropriate individualized asset allocation that is more likely to be maintained for the long-term.

We should diversify our investments using historical long-term rates of return, rather than short-term forecasts for stocks and bonds, as a basis for an asset allocation that serves our investment goals and tolerance for investment risk. By being properly diversified, it is emotionally easier for an investor to tolerate a downturn in the stock market.

We realize that over long periods of time there is likely no investment available to the average investor that will have better returns than the U.S. stock market. Market moves are largely unpredictable over the short-term, but over the long-term the stock market will generally appreciate 8-10% per year based on historical data. However, it is important to realize that those returns will not reliably arrive every year in a straight line. We learn to accept market fluctuations as a cost of doing business— the price for earning the superior investment returns that stocks provide. Optimally, we look to add to our stock positions during a general market decline.

We also remind ourselves that stocks represent a share of ownership in a business. We all recognize that some businesses have better characteristics than others. We endeavor to invest only in those businesses that have a consistent operating history and have prospered in both good and bad economic environments. We cannot control the market risk of a general market decline, but we can control our business risk by owning better businesses, whose stock prices generally hold up better in times of stock market declines. Therein lies another critical advantage—by owning superior businesses, we can hold them for a longer period of time without having to sell them and pay taxes on our capital gains.

We also realize that no investment is very good if the investor overpays for it. After determining that a business has the quality characteristics that we insist upon, we attempt to value the business and purchase it at a discount to what we think it is worth, thus decreasing our price risk and increasing our potential return. Even in a normal year, a company’s stock price is much more volatile than the value that a share in the business represents. Excellent businesses don’t go “on sale” very often, but they sometimes do during a general market decline or a short-term period in which the company’s earnings or sales are not as strong as Wall Street analysts expected. It is then that a true long-term investor is at a distinct advantage, as the price decline caused by short-term investors heading for the exits presents a low-risk buying opportunity.

We certainly are not recommending that investors remain ignorant of the economic environment. It is indeed important to evaluate potential investments relative to the current interest rate environment, and it is important for us to understand the economic environment facing each of our companies when determining their intrinsic value, but we do not start with a macroeconomic forecast and then fit our entire portfolio to that forecast.

Returning to our forecasters, theirs is a difficult game to play and there are a lot of ways that forecasts can go wrong. So let’s use a different strategy and mindset. Hopefully by now you are convinced that the most reliable factors in successful investing are establishing an asset allocation that you can maintain, correct analysis regarding the companies that you own combined with appropriate judgment about their long-term prospects, and a patient attitude. Forecasting is fun and interesting, but it is not particularly reliable—even by the experts!

City National Bank, as a matter of policy, does not give tax, accounting, regulatory or legal advice. The effectiveness of the strategies presented in this document will depend on the unique characteristics of your situation and on a number of complex factors. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. The strategies presented in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. The strategies were not written to support the promotion or marketing to another person of any transaction or matter addressed. Before implementation, you should consult with your other advisors on the tax, accounting and legal implications of the proposed strategies based on your particular circumstances.