Investment professionals are measured, in part, on their ability to forecast the future. Whether it is divining the direction of the global economy, or estimating the impact of Apple’s (AAPL) earnings from the sale of the new Apple Watch, performance of a managed portfolio is improved when these forecasts end up close to the mark.
Still, the future is notoriously hard to predict, especially over the multiple-year time frame that should represent an investor’s time horizon. Therefore, a prudent approach to developing a sound investment strategy is to start by establishing a base case outlook by drawing conclusions from the relevant economic and market information at hand. Then, consider what events could alter the fundamental outlook (either positively or negatively) and assign probabilities to the likelihood of an occurrence of any of these events. While not foolproof, this process helps illuminate the potential risks to the forecast, and quantifies the cost of being wrong.
At City National Rochdale, we have been bullish on the U.S. economy and the U.S. stock market for several years now. We believe the slow, steady upward trajectory of the economy, accompanied by loose monetary policy, represents a supportive backdrop for higher equity prices. We expect this trend to continue, although higher valuation levels are likely to cap the near-term appreciation potential.
Nonetheless, it is important to understand the events that could alter this relatively rosy forecast. Perhaps the most likely potential event would be a significant slowdown in U.S. economic growth that could lead to a sharp decline in stock prices. Of the ten 20% or more declines in the S&P 500 since 1929, eight of them were accompanied by an economic recession. While we see no evidence of recession on the horizon at present, we estimate the odds are about one-in-three that unexpected events cause a significant slowdown in U.S. growth.
Another risk worth considering is the possibility that the Fed moves too quickly to raise interest rates, slowing economic growth and exacerbating financial market volatility. Market historians point to the 1937 episode when the Fed moved to tighten monetary policy prematurely, causing a sharp setback in the economy’s recovery from the Great Depression. We believe the Fed is quite mindful of this risk, noting that the cost of moving too quickly is greater than being late. We believe the odds of such a policy mistake by the Fed are about 20%.
Further afield, investors should be aware of other events that could disrupt the upward trajectory of financial markets. This list would most likely include, but not be limited to: heightened geopolitical tensions in the Middle East, an expansion of the war against ISIS, the likelihood of Greece exiting the Eurozone, and civil unrest in countries dependent on oil revenues to support social spending. Even the severe drought in California could have an impact on municipal water utility revenues and nationwide food prices (although we believe the economic effect will be insignificant). Taken together, in our view, the probability of any of these events coming to fruition is about one-in-four.
Should one of these scenarios materialize, it is likely that some asset classes will perform much better than others. In an uncertain world, diversifying your portfolio against these risks should increase the probability of meeting your long-term investment goals.
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Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
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