Why Do We Even Try To Predict The Future?
Annual Predictions Are Rarely Correct
The year has started off with a healthy dose of volatility thanks to falling oil prices and renewed fears in Europe, which are creating wonderful opportunities for buyers. Now more than ever investors are anxious to hear from market pundits and investment managers on how we think equities will perform in 2015.
This question is certainly warranted given the events that have transpired over the last decade, and investors want to know that they are with a manager who is good at predicting annual returns because he/she seemingly has a “feel for the market.”
Unfortunately, annual forecasts are almost always wrong, and the very few who will get it right will be nothing more than lucky. Predicting annual returns from an asset class as emotionally sensitive as equities on a consistent basis is virtually impossible. Fear and greed are incredibly powerful and unpredictable forces that create dislocations in equity prices that often take months to normalize, which wreak havoc on short term forecasts.
Think back to some of the events that rocked equity markets in 2014. It’s implausible to assume that any investor would have accurately predicted that oil would drop over 45% in six months, Russia’s economy would come under tremendous pressure after invading the Ukraine, and Ebola would make it to the U.S.
Each of these events jolted equities, but they now appear to be either immaterial (Ebola) or actually beneficial to our economy (cheap oil). However, time was needed for the market to shake out the emotion and return to operating on fundamentals.
The chart below is one example of how poorly annual consensus estimates have predicted future outcomes. The green bar indicates the size of the difference between consensus estimates of annual U.S. GDP growth and the actual value at year end since 1969.
If annual consensus estimates were even remotely accurate over the past 45 years, then the green bars would be so small that they would be barely visible to the naked eye. Instead, the opposite is the case, which indicates that predicting GDP growth over a one year period is extremely difficult to do with any level of statistical accuracy.
This conclusion comes as no surprise considering the sheer number of variables that can impact GDP on such a short term basis. For example, who could have possibly predicted that a Polar Vortex was going to cripple consumer spending last year by preventing most of the country from leaving their homes in the dead of winter?
NOTE: U.S. GDP is nowhere near as volatile as the S&P 500, so imagine how hard it must be to estimate a number that is as emotionally sensitive as an annual equity index return if consensus can’t even get GDP right!
Predictions Are Not Useless
However, that’s not to say that predictions are completely useless, and Global Financial Private Capital has a disciplined process to create expected returns for all of the asset classes that we incorporate into our investment process. Rather, it’s important to know how to best use these forecasts as a manager and as an investor.
The process of forecasting an annual return forces a manager to think about all of the complexities in economies and financial markets, which creates a blueprint that we can then use to isolate the factors that currently matter the most. Therefore, as the year progresses and events transpire that were not predicted, we are able to assess the true impact to the economy and act accordingly.
Investors, on the other hand, are best served by using a manager’s forecast for more than just a measure of perceived skill. Comparing a forecast to the actual return at year end will give very little insight into a manager’s aptitude because you must dig deeper to eliminate the possibility of luck.
Rather, ask the manager how he/she derived the forecast and how he/she plans to act throughout the year if their original thesis turns on them. Only then will you get true value from their predictions for the coming months.
The bottom line is that annual forecasts are rarely accurate, but they are still a critical component to investing and provide tremendous value to both investors and managers alike.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser.