The Value Of Predictions

As we close out 2015, we find ourselves in one of the most comical parts of the year in finance.  The time to make predictions for 2016. Why is this comical?  Because Wall Street strategists are usually spectacularly wrong, yet investors still seem mesmerized by what they will say.  Wall Street strategists are not dumb.  There is no career risk in saying that the S&P 500 is going to go up 8 or 10% in a year.  Since that is the long-term average, you aren't really going out on a limb making this prediction.  No one is going to crucify you for it.  While you won't lose your job, you almost certainly won't be right.  In a recent article on MarketWatch 10 leading analysts are predicting a 6% gain for the S&P 500 next year.  Last year, these same analysts were looking for approximately 10%.  In fact, when you go back and look at analyst predictions, you will always see they predict returns in the upcoming year to be around 6 to 10%.  Let's take a look at the distribution of returns of the S&P 500 over the last 89 years to see what actually tends to happen:

Return distribution

We see that returns will be between 0 to 10% less than 15% of the time!  Here are some staggering statistics to consider as you ponder the validity of predictions:

  • Annual returns between 10 to 20% have been 46% more likely than annual returns between 0 and 10%
  • You've had the same odds of annual returns being between -10 and 0% versus 0 and 10%
  • It has been slightly better odds of generating annual returns between 30 and 40% versus 0 and 10%
  • 58% of all years measured (1926-2014) saw returns greater than 10%
  • 27% of all years measured (1926-2014) experienced negative returns

Rarely are returns average over a one-year period.  They have a tendency to be either much higher or lower than what analysts predict.  Given that analysts are probably right around 15% of the time (based on the frequency of returns above) it is hard to comprehend the value these predictions create for investors.  Maybe it's time to start realizing that the value of predictions is not for you, but the Wall Street firms (by selling you products) and the media (by you clicking on articles).  

2015= Flat Market, 2016= Your Guess Is As Good As Mine

As we get close to the end of 2015, it is fitting to look back and take a pulse of what happened this year in the markets.  The US stock market was especially interesting.  As I write this, the S&P 500 is trading just 50 points below where it started on January 1st this year, amounting to a 2.4% loss (does not include dividends).  Losses are uncommon, but not rare in the market.  In fact, since 1926 the S&P 500 has experienced 24 years with losses, representing 27% of those 89 years.  You would think that losses tend to happen when recessions or very adverse conditions show up in the economy.  While this is true some of the time, it's not always.  This year is a good example.  While we are sitting at a small loss today, it makes some sense to take a look at the fundamentals from these underlying stocks in the index (taken from Standard and Poors earnings and estimate report on 12/17/2015):

  • Q4 2015 operating earnings are estimated to be 8.5% higher than Q4 2014 operating earnings
  • Q4 2015 reported earnings are estimated to be 20.7% higher than Q4 2014 reported earnings
  • Q4 2015 annualized dividends are estimated to be 5.3% higher than Q4 2014 dividends

So, earnings and dividends improved, but the market fell.  How does that happen?  Remember, the market is a forward looking machine.  Buyers and sellers don't care what earnings are or were.  They only care what they WILL BE.  That is why it is so hard to beat the market.  Once the estimates start coming out on earnings for the first or second quarter of 2016, the market has priced that data in to the index value.  In fact, analysts are already predicting what earnings will be for this time next year (Q4 2016)!  Are they going to be right?  Probably not, but the current price of the market is probably the best guess out there.  Also, realize that millions of people, who have done their research are not only trying to answer the earnings question, but a million others like:

  • Where are interest rates going?
  • Will there be another terrorist attack and when?
  • How is the currency fluctuation in Japan going to impact my Norwegian stock holdings?
  • What will the weather patterns look like next year in Brazil?

Some of these may sound silly, but this is the type of analysis that is going on every second by analysts, hedge funds, and wall street investors.  I always chuckle when I hear someone tell me that Apple is undervalued, or that low interest rates are causing a bubble in tech stocks.  Almost unequivocally, they have no idea (though they don't know what they don't know).  They don't realize that there are literally millions of people analyzing all of these outside factors and they have set the price at where it is trading today.  When someone believes that price is not right, in reality, he is saying that he/she knows more than the millions of buyers and sellers out there who have set the price.  We did a small exercise with jelly beans at a client event that showed how the wisdom of crowds is usually a great way to determine the correct price of the market.  

The market looks like it is headed for a flat year.  The only silver lining that we can take away is that fundamentals did improve from a year ago.  Unfortunately, that tells us nothing about the future.  

Stock Picking Is A Losing Bet

Many of us at Greenspring used to be in the stock picking game.  It was really hard.  While our experience may have been anecdotal, there is new evidence coming out to support the idea that stock picking is a low probability strategy.  The Value Walk blog has posted a very interesting study on this topic.  Here are some of the major findings:

  • Since 1983, the US stock market has consisted of 8,054 publicly traded stocks (including delisted stocks)
  • 39% of stocks since 1983 have lost money
  • 64% of stocks underperformed the Russell 3000 during their lifetime
  • 18.5% of stocks lost at least 75% of their value over their lifetime

If you are keeping track at home, that means that you have a 1 in 3 chance to pick a stock that outperforms the index.  When I first read these statistics, I was astonished.  I figured that it should be about a 50/50 chance, since half the stocks should outperform and half should underperform.  The data tells us something different.  What we find is there is a very small contingent of stocks that have HUGE returns, while nearly 2/3rds failed to keep pace with the index.  To put it another way, index returns are significantly influenced by just a small group of winners.  If you don't happen to have some of these winners in your portfolio, you have a high probability of underperforming.  Here is a really interesting chart:

ind stock vs index

The chart shows that only about 6% of all the stocks significantly outpace the index, but they have a huge influence on the overall returns of the index.  What is the chance that you will be able to pick one or more of the stocks?  In looking at it from an attribution standpoint, it is even more astonishing. 25% of the stocks in the US over the past 30+ years have accounted for ALL of the gains!

attribution

When you start to understand the math and statistics behind stock picking, it should become increasingly clear that owning the entire market is a much safer and prudent strategy than trying to concentrate your bets.  

 

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.