Investment results for portfolio managers are largely determined by the accuracy of stock market predictions; however, the same cannot be said for strategists. Because of the high frequency that strategists’ forecasts are wrong, it is important to take a step back and analyze stock market projections before diving into risky investments.
Each year at Capstone Investment Financial Group, we compile information from Barron’s annual outlook, Stick with the Bull to discuss analysts’ predictions for the year ahead. While every year is different in terms of actual growth or loss, we can count on many key points to remain the same, including:
- Projections are often inaccurate
- Earnings growth is overstated
- Accuracy declines as conviction and consensus around projections increase
The Reliance on Trends for Market Projection
Strategists and most individuals make predictions by drawing out the most recent trend. This reliance on the continuation of trends is often the main problem with most prognostications. The recommendation to take an investment risk does not come from fundamental findings like valuations, earnings or economics, but rather a continuation of trends.
The analysis of looking at projections for the coming year is beneficial in that the consensus expectations are often wrong, especially at turning points. For example, in 2014, strategists expected the S&P 500 to increase by 10% while the actual return wound up to be 11.4%. Many strategists expected to see interest rates between 3.3% and 3.5% and were surprised when rates for the 10-year government bond rounded out at 1.4%; lower than any of the projections by a full 1.25%.
Earnings Growth Overstated
Another method that strategists are using to predict market gain is to study earnings growth. In 2014, advancement in this area came from cost cutting. Sales growth, a more continual driver of earnings growth, only rose 2% over the last 22 months (according to the S&P). What this means is that companies are benefiting from cutting costs; however, eliminating jobs and lowering interest costs are only temporary. Without sales growth to permanently drive earnings higher, there is a greater risk for inaccuracy in projecting earnings growth for the year ahead.
So what can we expect to see in 2015? It has been noted that the tendency for market projections to be wrong increases when strategists have more faith and agreement around a certain outcome, as was the case for the previous year. With companies improving earnings from cost cutting rather than sales growth and a recent history of unreliable previsions, there is little evidence to suggest that we will see dramatic market growth in our current year.
By James Cornehlsen, CFA