The folly of market forecasts

The attention investors give to market forecasts remains one of the great mysteries of human psychology. The evidence is overwhelming that no one possesses the ability to consistently call the direction of the stock market, bond yields, or currency rates. Yet every year the media invites experts to do what we know they can’t do. And every year investors listen to them, act on their recommendations and suffer the consequences.

One reason this is allowed to go on is that forecasters are celebrated when they’re right but rarely held accountable for their bad calls. So last year I clipped several articles that included forecasts for 2014 so we could evaluate how accurate they turned out to be.

Let’s start with the Outlook 2014 by CIBC World Markets, which included the following forecasts for equities, bonds and currencies:

• “US equities are hardly cheap given their run-up in 2013, but the Canadian market would appear to have more room to run … Within the equity market, what hasn’t played well in the past few years should now outperform. That includes equities tied to global growth rather than low interest rates, such as base metals and energy stocks.”
• The yield on 10-year Government of Canada bonds will rise from 2.68% in early December 2013 to 2.95% by the end of 2014.
• The Canadian dollar will strengthen modestly and the USD would end the year at about $1.05 CAD.

Swing and a miss, strike three. All of these forecasts were dead wrong: US stocks outperformed Canada again, thanks in part to a very strong US dollar that closed the year near $1.16 CAD. The sectors forecast to outperform were the biggest flops in an otherwise strong market: base metals (using the BMO S&P/TSX Equal Weight Global Base Metals ETF as a proxy) were down about 10% on the year, and energy stocks (based on the iShares S&P/TSX Capped Energy ETF) fell closer to 17%. And if you shortened your bond duration based on CIBC’s prediction of rising rates, well, that didn’t work out either: the yield on 10-year Canadas had fallen to 1.81% by December 30.

The worst of the rest

Next up: the Chief Investment Officer of Sun Life Global Investments, who shared his 2014 forecasts with Advisor’s Edge. He predicted the TSX would be in negative territory by the end of the year: “Stay away from Canada; we see a lot more headwinds continuing on.” Despite those headwinds, the broad Canadian market returned about 10% on the year.

The CIO went on to encourage investors to invest more in Europe and emerging markets (both lagged North America significantly in 2014), reduce their bond allocations (bonds had their best year since 2011), and declared that “dividend stocks will continue to pay off” (several popular dividend-focused ETFs in Canada and the US underperformed the broad market).

The forecasts from the US media were just as dismal. A survey of gurus by Business Insider resulted in a consensus forecast of 1,949 for the S&P 500 by the end of 2014: the index closed the year at 2,060, higher than all but one expert’s opinion. Over at the Motley Fool, investors were urged to shorten their bond exposure (oops, long bonds were up about 20%) and told that “Europe is particularly attractive” (for US investors, European stocks fell about 6%).

Tune them out

I don’t want to imply that these forecasters got everything wrong. On the contrary, some were dead on by predicting stable short-term interest rates, another strong year for US stocks, and weakness in commodity prices. Many others were half right—like those that got the direction right, but not the magnitude or the timing. But in any diverse collection of forecasts, many will turn out to be right simply by random chance. The lesson here is not that forecasts are always inaccurate: if they were, you could become wealthy being a contrarian. The point is that they’re worse than useless, as they are wrong far more often than they’re right. The only rational response is to ignore them all.

Instead of listening to the gurus this year, try a different tactic. Build a portfolio with a mix of stocks and bonds based on your ability, willingness and need to take risk. On the equity side, hold Canadian, US, international and emerging markets stocks at all times, and don’t try to guess which will be next year’s winner. With your fixed income, choose bonds or GICs according to your time horizon and your tolerance for volatility, not based on where you think interest rates will be next year.

So listen to the talking heads if you must, but remember William Bernstein’s advice in Rational Expectations: “Don’t even think about trying to extrapolate macroeconomic, demographic, and political events into an investment strategy. Say to yourself every day, ‘I cannot predict the future, therefore I diversify.’”