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Investing forecasts miss the key element - luck

By James Mackintosh, Financial Times, 08 December 2012

Every year, Wall Street produces thousands of pages of detailed analysis and pretty charts with cunning trading plans to take advantage of markets over the next 12 months. Inevitably, most are proved wrong.

The next few days will see the remaining investment banks produce their year-end targets for the S&P 500 and other main indices.

Given the dire record of Wall Street strategists as a group it is hard to see why they bother. Since the turn of the century, the average prediction a year ahead has been more than 10 per cent out, according to Bloomberg data. That almost matches the average market rise or fall over the same period.

Yet, investors have to make some sort of forecast to decide where to invest. Are bonds overpriced? Most of Wall Street seems to think so; Goldman Sachs, for example, expects a loss of 1.1 per cent next year on five-year US Treasuries, while Credit Suisse predicts the 10-year yield will jump from the current level below 1.6 to 2.25 per cent. This even though Credit Suisse predicts net new “safe” government bonds available after central bank purchases will be at the lowest level since 2000.

So will equities rise? Again, a quick survey of strategists suggests they will; Nomura puts the S&P 500 at 1,580 by the end of next year, a return of almost 13 per cent, near Goldman’s 1,575.

Investors trying to make their own forecasts should start by looking at history. The average return on the S&P 500 and its predecessor index since 1928 is a little over 7 per cent, and this is a favoured base for many, as it can be pulled from Bloomberg.

Having secured a base, one can then assess the positives and negatives. On the plus side for equities, central bankers are showing an unprecedented willingness to help support the economy (and so corporate profits), while China and the US housing market seem to be turning the corner.

On the negative side, European and US politics are dysfunctional; they could easily throw the US into recession and worsen Europe’s recession.

David Kostin at Goldman highlights profit margins as one of the biggest risks to his prediction. A 50 basis point drop in US margins would knock almost 5 per cent off earnings. That is the same effect, on his models, as economic growth coming in a full percentage point lower. With margins on the S&P 500 close to record highs, he predicts they will stay fairly flat for a second year. Those of a bearish nature will worry that high margins are unsustainable, particularly as they are bolstered by extremely high margins in technology. For now, though, there is no sign of margins being hit by rising wages or borrowing costs.

Is the performance of US stocks since 1928 really the best base to use? The annual average since 1871 is less than 6 per cent, data from Yale professor Robert Shiller show.

Include inflation and dividends, and the average annual real return in the US since 1900 was slightly higher, at 6.2 per cent, according to Elroy Dimson, Paul Marsh and Mike Staunton of London Business School.

That sounds like a good basis for a forecast - until one looks at other countries. The US stock market was among the best performing over the past century, as America grew into the sole superpower, attracted the world’s entrepreneurs and exploited vast natural resources (only South Africa and Australia, also powered by natural resources, did better). The average real return for the world was much weaker, at 5.4 per cent. Even this is questionable.

Should investors instead look at the equity risk premium, the amount by which shares beat bonds? For the world as a whole, that was 3.5 per cent a year, say Dimson, Marsh and Staunton. Use that as a base, and compare it with a 10-year US Treasury at 1.6 per cent, and the outlook is grim. Still, it could be worse. For the world excluding the US, bonds were a better bet than shares for the past 50 years.

If you are confused about how to forecast the next year’s returns, don’t worry. It is probably not worth the effort anyway. Over such a short period, chance dominates, as the extreme variations of returns suggest. Only just over two-thirds of the time was the one-year real return on world shares between minus 12 and plus 23 per cent in the past 112 years. Statistically, investors should have little confidence in any base for one-year forecasts.

Worse, luck may be becoming even more important, as Michael Mauboussin, Legg Mason’s chief investment strategist, points out in his book The Success Equation. In everything from investing to football, as the general level of skill of the participants increases, luck matters more. There can be little doubt that more effort, longer hours and fewer alcohol-fuelled lunches are involved in investment than a decade or a century ago. Ironically, that may make the predictions that emerge even less useful.

This article is intended to be for information purposes only and is not intended as promotional material in any respect. Fidelity has not been involved in the preparation, adoption or editing of this Third Party Content and do not explicitly or implicitly endorse or approve such content. Content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or investment by any Fidelity entity or any third-party.

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