The Perils of Market Forecasting

It’s that time of year again. The time of year where all the market experts make their 2020 predictions. You will see countless forecasts about what the economy will do in 2020. You will see many experts tell you what interest rates will do next year. And most of all, you will see a variety of predictions for where the S&P 500 is heading this year. The experts making these predictions will even do you the favor of giving you exact price targets so you know exactly what will happen.

But there will be one major problem with almost all of these predictions: they will be wrong.

I could try to explain why short-term forecasting is a waste of time, but I couldn’t do it any better than this quote from Jim O’Shaughnessy, the founder of O’Shaughnessy Asset Management. Here is Jim’s take on short-term forecasting.

And so, from our perspective, trying to make a successful forecast, short-term forecast, is a virtual impossibility, because, in the short term, there’s quite a bit of noise in the marketplace. And people mistake noise for signal, and they have a narrative about it, and it’s very believable, but unfortunately, often wrong. So we don’t make forecasts in terms of what the market’s going to do over short periods of time because quite frankly, we don’t know. And if others were honest, they would have to admit that they don’t know, either.

source: https://25iq.com/2018/07/21/lessons-from-jim-oshaughnessy/

Most forecasts are made out of self-interest. The goal is more to bring attention to the forecaster than to actually benefit investors. They also follow some common themes. So as we work our way through the height of the annual forecast season, I thought it might be a good time to point out some of the tricks of the trade. Here are some types of forecasts you should watch out for.

The Calendar Year Prediction

Predicting what will happen over a one-year period in the market is very difficult. Doing it consistently is essentially impossible. Yet every year, many of the top strategies at Wall Street’s most prestigious firms not only try to predict whether the market will go up or down, but they try to do it with complete accuracy by setting exact price targets. This exercise can be great for entertainment purposes, but it should have no impact on how you manage your portfolio.

To show how difficult this is to do, here are the year-end targets from analysts at some major Wall Street firms coming into 2019. As of this writing, the S&P 500 is at 3221. None of them were close. That isn’t because they aren’t smart or they aren’t skilled. It is because they were trying to predict something that is impossible to predict.

Strategist	Firm	2019 S&P 500 Target
Mike Wilson	Morgan Stanley	2750
Saira Malik	Nuveen	2840
Rob Sharps	T Rowe Price	2850
Savita Subramanian	BoA	2900
John Praveen	PGIM	3000
David Kostin	Goldman Sachs	3000
Edward Yardeni	Yardeni Research	3100
Tobias Levkovich	Citi Research	3100
Dubravko Lakos-Bujas	J.P. Morgan	3100
Steve Auth	Federated	3100

source: Barrons, 2019 Outlook: U.S. Stocks Could Rally About 10%

The Doom and Gloom

The playbook for this one is simple. You start by predicting that the stock market is in for a major decline. You talk about things like excessive debt that will break the system or extreme overvaluations. You might even present a chart or two that you have hand picked to best support your case. Then you repeat the process every single year until the decline you have predicted eventually comes. After that, you let everyone know you saw it coming and that investors would be well served by heeding your warnings going forward. What you will ignore is the fact that the market likely went up substantially from the point of your initial prediction, and that investors who followed you lost much more money missing those gains than they saved by missing the decline.

We have seen these types of predictions throughout this bull market. Some have been making the bear case since 2009, while others jumped on at some point along the way. But the one thing they all have in common is they have been wrong. Making the negative case for stocks can generate great headlines. Anyone who does it will also ultimately be proven right at some point. But for these types of predictions to have any value, they need to not only get the timing of the decline right, but also need to come close to timing the bottom. History tells us that almost none of the market pundits who try to do this can do it successfully. And those who can are probably trading their own and their client’s money and not telling everyone about it on Twitter.

The Crazy Prediction

If I want to get attention for my market call, I am not going to predict a 10% increase in the market this year. I need to predict something much bolder. That way, if I am right, I will get lots of publicity, but if I am wrong, everyone will probably forget I said it in the first place. From the perspective of getting the most attention, this approach makes sense. But from the perspective of the investor who listens to the prediction, it can be the most damaging. A good example of this are those who predicted that Bitcoin was going to $50,000 or $100,000 in a very short time when it had made its run up to $20,000. Those predictions were very unlikely to ever come true, but they had huge upside for those who made them if they worked out. And when they didn’t, most people just forgot about them.

The “I Have No Idea So I Will Just Predict the Average”

This is the exact opposite of the previous one and circles back around to those year-end Wall Street analyst forecasts I talked about before. If the market averages a 10 percent return per year and you want to limit your career risk from being wrong, the best approach is to just predict something close to that. That, however, doesn’t consider the variability of returns.

On average, the market returns about 10% per year over time, but the individual year returns are rarely close to that average. The chart below illustrates this concept by showing the annual returns of the S&P 500. Predicting a 10% return per year may be safe, but it is rarely correct.

source: https://www.macrotrends.net/2526/sp-500-historical-annual-returns

The Heads I Win, Tails I Also Win

The best-case scenario for a forecast is setting it up in such a way that it can’t be wrong. For example, I could predict that there is a 40% chance that we will have a bear market in 2020. By making a prediction like that, I have set myself up to claim victory no matter what happens. The odds of a bear market in any given year have been less than 40% historically. So if we get one, I can say that I called for above average odds of a bear market. But 40% is still less than an even bet. So if we don’t, I can talk about how I predicted a less than 50% chance of a bear market. Either way, I win. Either way, I get to say I was right.

The Dangers of Predicting the Unpredictable

These are just a few examples of the type of market forecasts I have seen. The one thing they all have in common is that they should be looked at as entertainment and not as a reason to make any changes in your portfolio. So as you read this year’s market forecasts, keep in mind that while they may be interesting, and may seem compelling when you read them, they will likely have limited value in telling you what is likely to happen in the future.