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More Forecasting Follies

MJG
edited May 2011 in Fund Discussions
Hi Guys,

From the mind of 6th Century BC Chinese Poet Lao Tzu: “Those who have knowledge, don't predict. Those who predict, don't have knowledge. "

And another beauty that represents one of the most egregiously inaccurate predictions made by astute IBM founder Thomas Watson in 1943: "I think there's a world market for maybe five computers."

And another beauty from an Anonymous source: "A good forecaster is not smarter than everyone else, he merely has his ignorance better organized.”

So with those cautionary quotes as an introduction, I offer my humble and likely inept forecasts for the equity market action for the remainder of the year.

I’m optimistic. At this posting, using the S&P 500 Index as a proxy for the equity marketplace, the year-to-date return is 5.8 %. At year’s end, I project that the S&P 500 Index will finish with a 9 % to 15 % annual return. I suspect the 15 % return is more likely. Here’s how I reached that forecast; it was not purely, but mostly, guesswork.

In simplified form, real equity returns are given by the sum of (1) dividend yields, (2) corporate profits, and (3) speculative expansion of the Price to Earnings (P/E) ratio. The anticipated actual return over the real return incorporates an adjustment for inflation.

The formula summarized in the previous paragraph captures market rewards with high fidelity over longer-term periods like ten years. Since the speculative component is hard (more likely impossible) to anticipate, sudden changes in the P/E ratio wreak havoc on any short-term prediction. That’s why market gurus often fail on an annual basis.

Nevertheless, I accept the challenge fully cognizant of the inherent risks. It may prove to be a totally useless market projection, but I’m sure it will stimulate a hot debate on this Forum. That’s its main purpose since I’m committed for the remainder of the year.

Here is my ignorant, but organized forecast.

Let’s start with the fundamental earnings growth and dividend yield portions of the expected returns equation. Just today, the WSJ reported the adjusted annual GDP growth rate prediction from Deutsche Bank, Goldman Sachs, JP Morgan, and Bank of America. The average real growth rate from these four exemplary sources is 2.68 % for 2011.

The S&P 500 reported dividend yield is 1.9 %. The Journal also shows a total CRB inflation rate of 2.3 %. Because of the deficit government spending policy, I expect this rate to increase: For the purposes of these analyses, I’ll use an annual expected inflation rate of 2.6 %.

Based on earlier studies, I have developed a very tight correlation between corporate earnings and GDP levels. If GDP grows 1 %, company profits will rise by 1.7 %.

Therefore, my forecast for the fundamental real market return will be (1.7 X 2.68) + 1.9 or about 6.5 %. Converting the real return to an actual return that reflects the inflation rate gives a fundamental forecasted equity market return of 9.1 % (6.5 + 2.6).

This analysis does not yet include any possible speculative contribution.

What can propel a positive speculative component? Many unclear factors like momentum, competitive returns from the bond vigilantes, liquidity, and investor sentiment. From my current perspective, these are mostly positive now, and reinforce and/or augment the forecasted returns based on market fundamentals. Here are some assessments.

The current market P/E ratio hovers around 16 depending on rearward or forward looking estimates. The annual dividend yields for the 10-year treasury and the DJ Corporate bond index are 3.1 % and 3.6 %, respectively. The modified Greenspan-Yardeni Fed model contrasts the equity market yield (inverse of the P/E ratio) against these baseline standards. That comparison demonstrates that the equity marketplace is presently undervalued. A regression to the mean belief system would suggest an incremental market price increase.

Presently, the S&P 500 Index is at about its 65-day moving average and approximately 6.5 % above its 200-day moving average. This is a positive momentum indicator and signals an equity commitment. That 6.5 % cushion offers a safety-net. If the 65-day average penetrates the 200-day moving average, a danger signal is transmitted. That’s not the scenario now.

Additionally, the 4-year Presidential cycle data set shows that the third year in that cycle is particularly rewarding to the equity investor. It has never delivered a negative performance during its history. The third year incremental output should enhance 2011 performance by 2 % to 5 % conservatively.

Liquidity has returned to the economy. The M2 money supply drop was arrested several months ago, and is presently reported by the St. Louis Fed to be at a 5 % annual growth rate. That’s sufficient funding to support an annual GDP growth rate that is at one-half that level. In fact, it adds somewhat to the inflationary pressures by providing excess liquidity. So the current government fiscal and monetary policies are both inflationary by design to stimulate the economy.

Investment sentiment has both fear and greed elements. The VIX Index is at its highest reading in over 2 months although its YTD trend is downward; that recent implied volatility denotes an increase in investor uncertainty and fear. The Investment Company Institute (ICI) data resource reports that investors are recovering confidence with a YTD money flow into stocks, hybrids, and bond entities, and fleeing money market products. That’s a mixed signal since investors are typically late into a bull market.

Finally, the AAII has maintained a sentiment indicator for many years. The historical long-term averages are that 39 % of AAII members are Bullish, 31 % are Neutral, and 30 % are Bearish. Today, 26 % are Bulls, 33 % are Neutral, and 41 % are Bears. Most market gurus use this cohort as a contrarian’s indicator. Since the current Bulls are below the historical average, the marketplace must have an upward trajectory from this contrarian’s viewpoint. Boy, we individual investors are held in low esteem.

Well, that’s my forecast, and I’m sticking to it. Overall, I’m hoping for a minimum of 9.1 % from fundamental considerations alone. Add some speculative components and the Presidential cycle consideration, and I’m forecasting a double-digit 2011 return of perhaps 15 %. That’s 9 % higher then the present S&P 500 YTD performance.

So, I’m staying the course, and I’m keeping costs to a minimum.

What are your assessments of the equity markets and my analysis? Your comments are encouraged and greatly appreciated.

Best Regards,


Comments

  • MJG:

    I was quite astonished to read this posting, having seen you frequently refer us to the skeptical analyses of market guru predictions at the cxoadvisory.com web site. I believe you are not claiming to be presenting a predictive model, but instead a set of fairly sophisticated summaries of indicators you believe have each individually been shown to be somewhat meaningful in the past. As such, you have provided an interesting window into your thought process.

    I am curious about three things:

    1. the effect on your decision-making ("staying the course") -- I assume this means you are satisfied with your current asset allocation, which includes some equity component. What alternatives to "staying the course" were you considering?

    2. the extent to which you have, in the past, reviewed these indicators (or perhaps similar, but changing sets of indicators) and decided to formulate a prediction, if only for yourself. Is this a regular part of your process?

    3. since you mention contrarian indicators, I am curious about to what extent this analysis accords with your sentiments. Is your head saying "be greedy" while your gut says "be fearful"? Or are head and gut in harmony?

    Thanks as always for putting your thoughts out here.

    gfb
  • MJG
    edited June 2011
    Hi Greg,

    Thank you for your perceptive comments and penetrating questions. You have it exactly right. I have a continuing and healthy skepticism with regard to anyone’s ability to forecast future market behavior with any persistent level of accuracy.

    I freely admit that I should be included in that dubious cohort. I suspect all private and professional investors, with a few rare and somewhat lucky exceptions, belong in that grouping.

    But, if you invest in the marketplace, forward looking projections are required, regardless of their inherent, inaccurate nature, and their many historical failures. How else are investment decisions to be made?

    I surely can claim many such forecasting failures. Mostly, I continue the exercise to identify market direction for the coming year, not absolute returns. The absolute return aspect of my analysis is more a by-product of the study, and not my primary takeaway. Asset Allocation decisions demand some imprecise prediction of expected returns for the major category holdings.

    I do not fully trust these low fidelity projections because of their lack of precision, not because the purveyors are charlatans. The uncertainties in the requisite inputs dominate the analysis outcome, and should cause all investors to pause and reflect. But some estimates are needed.

    I attempted to indicate my softness on forecasters by introducing the topic with the three quotes that I selected to demonstrate the low regard I hold for these overtaxed and overly hyped souls. The title of my submission is also a giveaway to my feelings.

    Perhaps a sidebar is needed to explain why I generated this forecast at this particular time. The back-story is as follows.

    I infrequently give an investment talk to a small group (like 30 expected) of senior citizens. I am scheduled to deliver one such talk next week, and am preparing. My posting reflects some of the data and points that I will make at this meeting. I often make my preparations do double duty.

    I’ve done this several times in the past, and have usually been disappointed by the Q&A session that follows the presentation. I attempt to present a top-down approach that identifies and summarizes general market returns, macroeconomic conditions, market momentum, valuation metrics, and investor (professional and private) sentiments.

    Most session participants are relatively unsophisticated, but reasonably wealthy, seniors. So I always conclude with an endorsement of passively managed mutual fund/ETF Index products. That’s my lame attempt at simplification. The meeting organizers have asked me to return for several years so they don’t object to that incomplete approach. I am definitely an amateur at this formal financial presentation stuff.

    However, some participants demand specific individual stock recommendations. They want tips; I don’t offer tips. I attempt to satisfy them with the types of analysis and projections that I submitted to this forum. I make a few numbers to illustrate my portfolio holdings, and this seems to gain the confidence of the session attendees.

    With respect to your specific questions, I decided to “stay the course” based on a similar analysis that I completed at the end of 2010. This update did not alter my market opinion. I started the year with a roughly 50 % equity asset allocation; I will finish the year with a similar percentage. I was considering a possible reduction of my 50/50 equity/fixed income allocation to a 30/70 mix. Based on my analysis and judgment of its applicability, I rejected the candidate change. Of course, if a Black Swan appears I will reassess my positions.

    I usually do this top-down assessment once each year. I have both added and subtracted signal elements from the mix over time. I try to limit the factors that I include in my study since I have limited resources and even more limited time to devote to the process. I have completely abandoned individual equity and bond holdings because of the laborious and endless analyses and decisions needed to manage a diversified portfolio. I now exclusively use mutual fund/ETF products. Consequently I feel the top-down, macro-oriented approach is consistent with my current investing philosophy.

    Sentiment indicators are a minor part of my investment decision making. I try hard not to follow the wisdom of the crowd since it is prone to both fear and greed stampedes. I do NOT follow the markets on a daily basis. I do subscribe to the WSJ and spend 15 minutes each day looking at their data sets. I evaluate my holdings quarterly. Today, I do not know, and do not care to know, its present value. In this way, I tend to isolate myself from fleeting market sentiment.

    I have never been a greedy investor. My bottom-line goal is to do the market averages over a 5-year period which should capture some market cycles. I do have a portion of my portfolio committed to active management. However, over the long haul, my most optimistic hope is that I incrementally add 2 % return above market performance. I do not characterize that as an excessively greedy goal.

    Greg, thanks for your comments. In the deep recesses of my mind I recall getting a CXO Advisory Group heads-up from a FundAlarm poster; I believe that poster was you. I owe you another thanks for that fine input.

    Best Wishes.


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