It’s that time of year when investors clamor for insight into where the stock market is headed. Before we turn to some of the brightest minds on Wall Street, let’s analyze their track record. The chart below compares the average annual forecast for the S&P 500 (blue bars) to the actual result at year-end (purple bars). These estimates were compiled by averaging the individual forecasts from Market Strategists employed by some of the most prestigious institutions on Wall Street.
The only discernable trend is that their track record has been consistently abysmal. There were only three years when this very well-informed estimate came within 25% of the actual return (2005, 2010, and 2016).
These are not dumb people. They earned PhDs from top universities, work so many hours that they no longer remember their kids’ names, and are paid millions. They also have unlimited budgets, access to more data than they can consume, and an army of geniuses working for them to crunch the numbers. Yet they appear to be terrible at doing what they’ve been hired to do - forecasting annual returns.
How is this possible? Furthermore, where can investors get more reliable forecasts if the professionals can’t get it right?
Getting Emotional
I obtained undergraduate degrees in electrical engineering and mathematics. The curricula were very structured and precise for a reason. As long as I accurately calculated all inputs, stuck to proven mathematical formulas, and obeyed the laws of science, prediction was possible.
However, financial markets do not operate on Newtonian physics. Think back to the events that impacted equity markets in 2022. I don’t recall seeing a single forecast predicting the Fed would raise interest rates at a pace unseen in four decades. Nor was there any mention that gasoline prices would reach high single digits before the summer, only to come crashing down by year end. And I’m pretty sure few, if any, predicted the wave of Ponzi schemes and other failures that rocked cryptocurrencies.
Fear and greed are unpredictable forces that create dislocations in equity prices. These often take months to stabilize, wreaking havoc on short-term estimates. Strategists may as well publish quarterly, monthly, or even daily forecasts because they are just as arbitrary as a single year.
The reality of their job is that they are being paid to do the impossible armed with an ineffective toolkit. Using process and logic to predict the mood of investors a year from now is like using antibiotics to cure a viral infection. What they really need is a crystal ball, and those are hard to come by.
But that’s not to say forecasting is a waste of time. Most business owners would agree that projecting sales and expenses at the beginning of each fiscal year is a valuable exercise. These estimates are almost always wrong, but doing so forces them to think about what could impact their business.
The same applies to the research these strategists publish. They might uncover investment themes and risks a reader may have yet to consider. Incorporating the viewpoints of those who think differently or have specialized expertise might help them avoid costly mistakes. That’s why I try to read as many of them as possible.
Simply put, it’s ok to follow market forecasts from smart people, but take them with a grain of salt. Forecasters are either lucky or wrong, and luck usually runs out.
The Bottom Line
There’s an old saying:
“He who lives by the crystal ball will eat broken glass.”
We’re only a few weeks into 2023, and I can’t think of a time that posed more challenges to forecasting. It feels like half the economic data point to an imminent recession. Housing has slowed more than at any other time since 2008, corporate profits have been nothing to write home about, and it seems like we can’t go a day without another tech behemoth announcing massive layoffs. Furthermore, the yield curve has been flashing warning signs for nearly a year, and manufacturing surveys suggest the economy is slowing.
But the other half indicates continued strength. Retail sales dipped late last year only to rebound spectacularly in January, and despite layoffs, the job market remains strong. We have the lowest unemployment rate since 19691, recent payroll strength surprised everyone, and companies like Chipotle want to hire 15,000 new workers2.
Add in investor sentiment, and the crystal ball becomes even murkier. It seems like any time bad news is reported, it’s good news for stocks because traders assume it will encourage the Fed to stop raising interest rates. But this will only last so long, and trying to guess when bad news will become bad news again risks consuming a lot of broken glass.
Therefore, rather than using annual forecasts, we remain focused on financial planning. We do things like stress test portfolios using over 50,000 different scenarios to ensure the probability of success stays within an acceptable range.
We also run cash flow analyses to try to ensure our clients don’t run out of money in retirement. We do this by assuming bad years like 2022 will happen occasionally and then plan for them upfront. That way, we don’t have to guess when they will occur, nor should they derail investors from their goals.
We also utilize solutions that can offer defined outcomes, like eliminating downside risk and/or offering a fixed rate of return. These can further increase the probability of success and have zero reliance on market forecasts.
The bottom line is that if Wall Street can’t get it right, neither can you, me, nor anyone else. But that’s ok because success comes from planning, not guessing.
Sources
1 Bloomberg. As of 2/24/2023
2 https://www.cnbc.com/2023/01/26/chipotle-hiring-restaurant-workers-for-spring.html
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.