I had the pleasure of dining with a group of friends recently at one of the fine wineries along Lake Erie. Near the entrance was a rock hanging from a chain – i.e. a “weather rock”. One of our friends explained how it works. When it’s wet, there is rain. When it’s white, it’s snowing. And when it’s swinging, it’s windy.
Noting that it’s easy to predict the past, another astute member of our group asked if my HighView partners and I were good at financial predictions. I remarked that we’re definitely better than the weather rock. This reminded me that forecasting is an ironic and humbling exercise. The irony: short-term predictions are notoriously more difficult than longer-term forecasts.
When asked for shorter-term predictions, I always respond candidly that I can guess what’s going to happen from year to year but I don’t know. Nobody does despite the proliferation of forecasts that our industry produces for each coming quarter, six months or year. And stock market returns from the past several years illustrate this nicely.
Correct prediction; unforeseen result
Recall that the U.S. housing market was the first in a long line of economic dominos to launch the global financial crisis. Some who predicted this – and there were a few – assumed that U.S. stocks would feel the brunt of the stock market pain and that investors would trip over themselves to dump their U.S. Treasuries.
But the opposite happened. U.S. stocks lost less than most other stock markets and the U.S. dollar soared in value (pulling Treasuries up with it).
Stock market quiz – economy vs. stock market
Here’s a short quiz to test your more recent memories. Which of the following regions boasted the highest stock market performance in calendar 2012 – Europe, North America, Asia-Pacific or Emerging Markets?
Many are surprised to learn that stock markets of faster-growing emerging markets (+16%) and recovering North America (+13%) trailed far behind Europe’s 20% stock market performance in 2012 despite the region’s limping economies. Greece, by the way, was one of the top performers with a sizzling return of 25% – the 6th best among European markets. All returns are in Canadian dollar terms.
But not every year’s performance is in sharp contrast to the ‘stories’ of the day. China’s slowing economy in 2013 has aligned with its year-to-date flat stock market performance when measured in Loonies. And the continuing U.S. recovery has been met with a 27% YTD gain through July 26. But there are always surprises.
Ireland’s economy has shrunk a bit year-over-year but its stock market has modestly outpaced the strong U.S. market this year. Two divergent economic stories but nearly identical stock market returns.
Italian stocks are up more than 8% this year in Canadian dollars despite high unemployment, a shrinking economy and a sky-high debt load. The point being that year-to-year returns are rather unpredictable and are sometimes tied to what’s happening in an economy and sometimes not.
When returns are seemingly illogical, price sometimes plays a key role in explaining a market’s returns. Indeed, price is a key driver of our longer-term return forecasts.
We spend a lot of time with clients understanding how they accumulated their wealth and what they want it to accomplish for them. We translate that conversation into a target rate of return required to achieve a client’s goals and objectives.
There is an implicit assumption that we expect our recommended portfolio to perform at the client’s target return level or higher – while exposing our client to an acceptable level of risk. Some method of return forecasting is required to have comfort with this implied assumption and conviction in our recommendations. And it’s the reason why we are able to have candid conversations about any gaps between the risk clients are prepared to take and the performance levels they need.
Our forecasts blend history with common-sense forward-looking judgement calls. Accordingly, our expected stock market returns are a function of current valuation, expected earnings growth and the expected change in valuation. The same method is used for bonds, minus the earnings growth.
This method has served us well by ungluing our minds from the more recent past – which is something more investors and advisors need to do.