Tis The Season
A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.
— Warren Buffet
As the year comes to a close, it usually brings with it a season of happiness: cheerful occasions, a time for family, holidays, giving and receiving of gifts, laughter, and joy. It also brings about the annual ritual of banks, asset managers, and financial institutions publishing their predictions and outlooks for the coming year.
These reports are typically accompanied by recommended investment strategies and actions that are aimed at trying to avoid the next crisis or trying to capture the next “great” investment opportunity. However, as we have written before numerous times, it may serve your mental state and sanity better not to look forward or give weight to any of these predictions.
This is not to say that any of these outlooks were written by amateurs. After all, the financial industry is staffed full of well educated people, who work long hours trying to figure out what is going on. That said, the fundamental problem about establishing your investment decisions on these outlooks is that it is impossible to forecast the prices of stock and bond markets the very next day, let alone one year in advance, with both consistency and accuracy. In a similar fashion, checking whether it is going to rain on 28th May 2023 will not yield dependable results; you’d probably only want to check the forecast on the day itself, and even then, the weather can turn and change in a matter of moments.
Accuracy of Forecasts
Take this year’s S&P 500 market forecasts for example. At the beginning of the year, the average analyst forecast was for a 8% return in 2022. With only a couple of weeks to go and with the US market around -20% (in USD terms), its unlikely that this forecast will be reached.
This is not the first time that forecasts are so horribly off. In 2021, the aggregate expectation was for markets to be flat — given that the world was still struggling with COVID-19 lockdowns and that the global economy would find some time to regain its footing. Markets ended the year over +20%.
And what about 2020? The median consensus was for markets to be up 2.7%. The year ended with a gain of more than +10%. But what made it jarringly worse was after the Mar 2020 crash, analysts revised their expectations downwards, predicting that markets would end up at -11% instead.
Statistician and author, Salil Mehta analysed the stock market forecasts of big institutions such as JP Morgan, Citibank, Goldman Sachs, UBS and more. His data showed (chart below) that the forecasts ranged from -30% off (under-estimated final price by 30%) to +90% (over-estimated final price by 90%).
Can Data Help in Predictions?
So let’s say you want hard data to form your thesis on where the market can go. After all, the prices in stock markets are based on fundamentals which are related to the earnings of the companies listed in these markets right?
Surprisingly, correctly predicting the future earnings of companies tells you very little about what their future stock price would be. Research shows (chart below) that the relationship between changes in company earnings and changes in stock prices is almost zero.
The Future?
So what about 2023? At the moment, the median estimate for the stock market next year is a gain of around 3.8% (from current prices). However, if you delve into the various reports you will find that there is a huge disparity among the forecasts. There is a big divide between analysts who expect a positive 2023, with those who expect a dismal year instead. In fact, this disagreement is at a number not seen since 2009 — when the bear market bottomed out and stocks had a roaring recovery year (chart below).
So which market outlook do you want to follow? If you’re still inclined to try to invest using forecasts, it is probably time to pay less attention to such reports. A study on the accuracy of market forecasts showed that nearly 95% of market forecasts were less than 70% accurate. Why is 70% a significant probability to surpass? It’s because every investment decision or trade needs both a buy and sell call. A 70% correct buy call and a 70% correct sell call will give you an investment outcome that is correct only 49% of the time. Even with an excellent 78% prediction accuracy of the top forecaster, it only takes a third call to bring your accuracy below 50%.
So how do you invest without forecasts and predictions? For starters, diversification is a sure-fire way to reduce short-term and idiosyncratic risk from singular investments blowing up (investors with concentrated technology and cryptocurrency portfolios would have had a year they’d rather forget). Diversification also takes away the headache of trying to figure out where to park your money year after year. It also removes the risk of you accidentally allocating to a country or sector which went down instead of up.
Second, is the power of time. As long as you are sufficiently diversified, it is possible to forecast the long-term returns of markets as this research from Nobel laureate Eugene Fama shows. This is very powerful knowledge because you don’t need to know whether the Fed is raising or cutting rates, whether oil prices are over $100, whether a recession, or a new geopolitical conflict may occur.
Betting on the direction of various assets and hanging on what investment outlooks say leans more towards trading and gambling, and not investing. Stay humble, relying on time-tested tenets of diversification and time in the market will help you get a more reliable and predictable outcome. If you still feel unsure about 2023, talk to us to allow us to help guide you through these uncertain times.
