Too many investors focus on ‘outlook’ and ‘trend’
Here we go again. Wall Street firms are proudly presenting their forecasts for the stock market this coming year. I have a built in bias against the usefulness of forecasts. Since I make it a rule to challenge my ‘confirmation bias’, I decided to dig into it a bit to find out what they have in mind when they do this.
First, let me explain where I am coming from. Warren Buffett has written: “We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be in a year from now.” (Buffett W. E. The Essays of Warren Buffett: Lessons for Corporate America. Lawrence A. Cunningham 1998) p.71.
And either Mark Twain or Yogi Berra said: ““It is dangerous to make forecasts, especially about the future.”
So, with that in mind, here’s what the brains on Wall Street have come up with:
Why do they do it?
It’s possible they do it because they always have. It’s a noble tradition. In a lecture given by Benjamin Graham on November 15, 1963 at the Town Hall, St. Francis Hotel, he commented on predictions saying: “I would like to point out that the last time I made any specific stock market predictions was in the year 1914, when my firm judged me qualified to write their daily market letter, based on the fact that I had one month’s experience in Wall Street. Since then I have given up making predictions.” (Graham, The Intelligent Investor, fourth revised edition 1963) p.7
I suppose, in truth, they do it because they are in the business of giving advice about the way forward. Forecasts are part of what they have to sell. With luck, an analyst will get their forecast right for a few years and develop a reputation for prescience.
To what end? Discretionary asset allocation rebalancing
This is the interesting part. Here’s what we get from the asset management arm of Canada’s largest bank:
The RBC Global Asset Management Investment Strategy Committee wrote recently:
“Although valuations are elevated, we think stocks can still deliver modest returns given low interest rates, transitory inflation and sustained corporate profit growth. We look for mid-single-digit gains in North American equities, with slightly better return potential elsewhere over the year ahead.”
Why do we need to know this? It’s because they recommend a discretionary asset allocation rebalancing strategy. It’s explained this way:
“Asset mix – the allocation within portfolios to stocks, bonds and cash – should include both strategic and tactical elements. Strategic asset mix addresses the blend of the major asset classes offering the risk/ return trade-off best suited to an investor’s profile. It can be considered to be the benchmark investment plan that anchors a portfolio through many business and investment cycles, independent of a near-term view of the prospects for the economy and related expectations for capital markets. Tactical asset allocation refers to fine tuning around the strategic setting in an effort to add value by taking advantage of shorter term fluctuations in markets.” (Emphasis added)
They conclude: “Our recommendation is targeted at the Balanced profile where the benchmark (strategic neutral) setting is 60% equities, 38% fixed income, and 2% cash.”
I’m assuming the RBC Global Asset Management is typical of Wall Street.
In a nutshell
What they recommend is a very specific investment style. It is a variant of the classic 60/40 stock/bond approach. They say you should increase or decrease your weighting of stocks (the fine tuning part) based on their outlook for the stock market, the economy, future interest rates and other factors.
This investment style incorporates market timing. Market timing is the effort to buy a stock or stocks when the outlook is good and sell them when the outlook darkens. It is one of the most sure fire ways of losing money in the stock market. It comes freighted with all the perils of behavioral biases.
Not only is such forecasting virtually impossible, but there is often no correlation between the economy and the stock market. The stock market and the economy very often do not march to the same drummer. They are often out of step. So, trying to pursue stock market timing based on one’s outlook for the economy is not a good idea.
It’s not just me who thinks this. As John Templeton says in his Maxim 14: “Too many investors focus on ‘outlook’ and ‘trend’. Therefore, more profit is made by focusing on value.”
A different approach to the future
Over the long haul stocks outperform bonds. The outperformance is caused by the equity risk premium. Stocks are thought to be more risky than bonds and the market prices common stocks to reward investors with that premium. This will hold true as long as stocks are thought to be riskier.
My approach to investing has been to take advantage of the equity risk premium and invest 100% in common stocks (subject to a bubble exception). I buy only superb companies and then, only at very attractive prices. I follow a KISS principle explained here.
There is a paradox about future investment returns. Over the short and medium term stock returns are subject to all the vagaries of the stock market, the economy, interest rates and other factors. Anything could happen. Even bad things. But, over the long haul real stock returns are relatively predictable. For a discussion of this check out the Motherlode Chapter 1. Stocks Beat Every Other Asset Class
Investing is quintessentially a game (albeit serious) of probabilities. Take a look at the following chart. It is titled “Range of Annualized Returns”. What is shows is the likely range (drawdowns in red and gains in green) and likely average annual returns for each time frame over the next 30 years.
What we see is that (based on the historic range of volatility) if you have a one year investment horizon, you might see at the end of that year a paper loss of some 50% or you might see a paper gain of some 50%. But, if your investment horizon is more than 25 years, you might see an average yearly return ranging from about zero to about 15%, with the average about 6 or 7%. My idea has been to go with the long term averages and hopefully even beat them.
Source: RBC Direct Investing
We started this post with the quote from Warren Buffett that forecasting where the stock market will be a year from now plays no part in his approach to investing. When you invest for the long haul in superb companies with a diversified and balanced portfolio, you don’t need to practice any form of market timing. With that thought, I pay no attention to Wall Street forecasts of where the S&P 500 will be a year from now.
I have written a more general post on asset allocation:
My thoughts on asset allocation
My post last year about stock market and economic predictions is still valid. It comes at the topic in a different way:
Why you can safely ignore market (and economic) predictions.
In the background we also need to be alert to bubbles, but that is another topic.
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