By Guest Blogger Doug Rowat
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It’s beginning to look a lot like Christmas.
Is it the stockings hung by the chimney with care, visions of sugar plums dancing in my head, cousin Eddie’s RV pulling up to the Griswold’s? No. It’s the market-outlook reports that are clogging my inbox.
Here’s a sample:
Click to enlarge
It won’t stop here, of course. The reports will continue to pour in for the next several weeks. It’s an investment-industry end-of-the-year tradition. And the outlooks are (as they always are) unwaveringly bullish.
But this annual tradition is a fair bit of bunk. First, the focus on outlook at this time of year is purely arbitrary. The outlook really shouldn’t matter more now than it does in, say, May or August. Secondly, these forecasts are so frequently wrong that they’re of limited value. Investment manager Barry Ritholtz sums up the usefulness of year-ahead market outlooks nicely:
These are counter-productive exercises for investors. First, they are little more than guesses. I mean that literally; there is no valid science to estimating stock prices, interest rates, inflation, bond yields, gold, bitcoin or whatever 12 months out.
Consider: How many strategists had “Global Pandemic, one million deaths, 34% market crash, but with huge gains in FAANMG stocks and a 12% annual S&P500 gain” in their 2020 Outlooks? None.
The future is both unknown and unknowable. Don’t blame Covid—wars, pandemics, natural disasters and other tail risk events are a feature, not a bug. The unprecedented occurs with alarming regularity. This is why the forecasters never stand a chance over the course of a year.
Heavy-hitter Morgan Stanley recently raised its S&P 500 target for next year to 3,900, roughly 6.5% upside from current levels. I haven’t read its report, but no doubt Morgan Stanley carefully weighed central bank policy, Biden’s economic policies, vaccine rollout, corporate profitability, and god knows what else, to come up with its tepid, middle-of-the-road 6.5% upside.
But let’s see if I could duplicate a similar, and probably equally accurate (or inaccurate), 2021 forecast with just a bit of quick back-of-the-envelope math. First, US equity markets usually trade higher. With remarkable consistency under many scenarios, markets trade higher more than 70% of the time (73.1% to be exact). And maybe I’ll tilt those probabilities even higher because it’s the first year of Biden’s presidential term (see largest column in chart below). So my first wager? The US market will move higher next year. So far, me and Morgan Stanley are on the same page.
Odds the market will rise in any given year
Source: MarketWatch; US market data going back to 1793
And finally, the determination of the gain’s magnitude. Looking long term, what’s the historical distribution of US equity-market returns? US equities over almost the past 200 years most frequently have returns that fall into a range of between 0 and 20% (the peak areas of the pyramid or bell curve below). So, historical likelihoods support my estimating within this range. And if I shade my next-year forecast a bit more conservatively towards the lower end of this range, I arrive at an identical 6.5% upside estimate. No hours of research, no carefully argued fundamental thesis and no expensive analyst team required.
Pyramid of US equity returns past 195 years
Source: Visual Capitalist
The problem, of course, is that annual returns with great frequency fall to the edges of the pyramid or bell curve. Almost 60% of the time they fall outside of the range that I mentioned above. More than a quarter of the time returns are flat-out negative and more than 13% of the time returns fall into a -10% to -50% range—a fairly significant probability of such a lousy outcome. But no Wall Street analyst ever frames their year-ahead outlook with a negative return prediction, and certainly not a forecast of a double-digit decline—at least no analyst who wants long-term job security.
But such declines happen. A lot. This is why you should always maintain a balanced and diversified portfolio: for the predictions that Wall Street analysts will never make—and for the disruptive market events and sharp declines that will nevertheless still occur despite the sunny forecasts.
I’ve quoted New York Times columnist Jeff Sommer before on this blog, and his past observations on forecasting are always relevant this time of year:
Since the start of 2000, The Standard & Poor’s 500-stock index has ended in negative territory in five calendar years (2000, 2001, 2002, 2008 and 2015) and has been virtually flat once (in 2011). But while a handful of individual forecasts have, from time to time, predicted mildly negative years for stocks, the Wall Street consensus in every single year since 2000 has predicted a rising market.
Consider the calamity of 2008. … The S.&P. 500 fell 38.5% in the course of those 12 months…the forecast for 2008 was unusually bullish, calling for a rise of 11.1 percent. Wall Street missed the mark by 49 percentage points that year.
So, perhaps the only truly useful prediction is George Carlin’s weather forecast: “Weather forecast for tonight: dark. Continued dark overnight, with widely scattered light by morning.”
But knowing the pointlessness of all of these end-of-year investment-industry forecasts, am I still going to carefully construct a detailed 2021 market-outlook report for my clients?
You’re damn right I am. You don’t mess with tradition.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.