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Thursday, December 20, 2012

Before You Read All those Forecasts for The Stock Market For 2013……

You might want to read this paper from Vanguard's research department on the utility of major macro approaches to predicting future stock returns.  The conclusions are so well stated I’ll reprint a long quote from the article:
Asset allocation and the difficulty
of predicting the future
We’ve shown that forecasting stock returns is a
difficult endeavor, and essentially impossible in the
short term. Even over longer time horizons, many
metrics and rough “rules of thumb” commonly
assumed to have predictive ability have had little
or no power in explaining the long-run equity return
over inflation. Although valuations have been the
most useful measure in this regard, even they
have performed modestly, leaving nearly 60%
of the variation in long-term returns unexplained.
What predictive power valuations do have is
further clouded by our observation that different
valuations, although statistically equivalent, can
produce different “point forecasts” for future
stock returns.
This underscores a key principle in Vanguard’s
approach to investing: The future is difficult to
predict. As such, we encourage investors not to
focus on the “point forecasts” that result from
various forecasting models and instead turn their
attention to the distribution of potential future
Once future prospects are viewed in a distributional
framework, the benefits of strategic asset allocation
become clear. A focus on the distribution of possible
outcomes highlights the benefits and trade-offs of
changing a stock allocation: Stocks have a higher
average expected return than many less-risky asset
classes, but with a much wider distribution, or level
of risk. Diversifying equities with an allocation to
fixed income assets can be an attractive option for
those investors interested in mitigating the “tails” in
this wide distribution, and thereby treating the future
with the humility it deserves

A couple points from the article:

·         In the short term markets are basically unpredictable.      
·         In the longer term p/e ratios offer some predictability high p/e ratios predict lower long term returns as they revert to the mean and vice versa. But even this measure had only correlation of .40 to future returns meaning even in the best case 60% of market returns were unpredictable.

Some Implications for Investors:

1.       These relationships between p/e ratios and future returns might argue for a bit of a “value tilt” in a portfolio overweighting low p/e stocks. But such a strategy can only be expected to generate a higher long term return if the investor is willing to stick with the strategy for a long period.


 During the tech boom of the 1990s with growth significantly outperforming value many investors sold their value stocks. And since there is a herding (momentum) factor in the shorter term markets can “overshoot” taking prices and p/e ratios higher before they revert to the mean and fall. This makes it even harder for value investors to hold on.  In light of human nature and well known factors in behavioral finance one might be well advised not to weight too highly to value stocks.

Professional investors are not immune to the tendency to join the move to high p/e stocks and abandon value investing …even if their basic instincts tell them not to do so. Professional investors face “benchmark risk” which translates into “career risk”. A period of 3,2, or even 1 year of underperformance vs. a benchmark  such as the S+P 500 will lose to outflows of funds from the pool of assets under management. Less assets under management = lower compensation for the manager and the fund company in turn raising “career risk” for the manager. Hence a tendency for even the more knowledgeable professional investor to join the herd in a bubble rather than “fight the tape”.

Recognizing these tendencies it’s not hard to see why bubbles and busts can occur in the short term and why virtually all the great (few as they are) long term investors have been value investors and why all the  most successful factor based investing strategies (used by passive vehicles such as ETFs and index funds) use some variant of a value tilt even while they may differ on exact methodology.

2. Point forecasts are basically useless but longer term probabilistic approaches can be useful.

I am in the midst of reading Nate Silver’s The Signal and the Noise  and he reinforces this approach. While it is extremely difficult to make a point forecast it is far easier to forecast a range of returns and a probability of outcomes. Although people focused on his highly successful forecasts for the results of the last two elections they might have overlooked the fact that he always gave his forecasts in terms of  probabilities rather than a point forecast. He has some interesting things to say about financial markets
In this interview (interestingly the motley fool which hosts the interview promotes exactly the approach Silver argues against)

He pretty much lines up with the view the view that  one can forecast the long term probability of a range of return with much greater success than trying to make a point forecast
probability of identifying the probability of returns over a ten year period far more useful than a point forecast. While it may disappoint those looking for a point forecast here is how Vanguard views the outlook for future returns:

Turning to real returns, we estimate a
slightly greater than 50% likelihood that over the
2012–2022 period, the broad U.S. stock market
will earn at least a 5% average annualized real
return. As such, we feel our expectation for the
forward real return is quite in line with the historical
average of 6.8% that has been observed since 1926,
and does not represent a drastic change in the
risk–reward characteristics of the equity market.

Match that up with a commonly held approach that current yields represent the best forecast of future  nominal bond returns one could get an idea of a portfolios expected return. A strong case has been made that this argues for a negative real return on treasury securities. As a consequence it would argue for a significant weighting in corporate bonds as well avoiding long duration since a low future inflation expectation is built into future corporate and treasury bond yields.

So final thought: skip the end of year forecast articles, instead spend your time enjoying family and friends over the holidays.

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