At AUM in a Box, we have a tradition of discussing analysts’ predictions for the year ahead. We compile information based on Barron’s annual outlook, “Bullish on 2014” from Barrons.com. Our discussion begins first by looking at how the strategists did in the past year and then looking at the projections for the upcoming year. Specifically, our discussions cover the following:
- Projections are often inaccurate
- Accuracy declines as conviction and consensus around projections increase
- The year ahead often contains lofty projections
- Earnings growth is overstated
An analysis of looking at projections for the year to come is beneficial in that the consensus expectations are often wrong, especially at turning points. For instance, at the end of 2007, stock market strategists expected the market to increase by an average of 11%. Two expected an increase of more than 21% increase. There was only one analyst who did not expect an increase at all. The final result was a decline of 37%.
Several years ago Forbes columnist, Ken Fisher began advocating financial analyses, and I have continued this practice ever since.
ACCURACY OF PROJECTIONS
Last year, on average, strategists expected the S&P 500 to increase by more than 15%. The actual return was just over 30% with dividends. Projections for the S&P 500 were closer to the mark than projections for bonds and earnings. All of the strategists expected interest rates between 2% and 2.5%. Actual interest rates for the 10-year government bond were 2.9%, which was higher than any of the projections. The actual rate is shown in Figure 1.
Ken Fisher’s original analysis recognized that strategists and most individuals make predictions by drawing out the most recent trend. This reliance on the continuation of a specific trend is often the main problem with most prognostications.
For example, Stephen Auth of Federated Investors studied the market’s performance after two consecutive years of double-digit returns. In 50% of cases, stocks advanced the next year. He concluded, “Two years of big rises is not a reason to not be bullish.” His study suggests that most recommendations are not coming from anything fundamental like valuations, earnings or economics, but rather a continuation of trends.
An additional concern is that expectations for 2014 are tightly concentrated around a 10% growth. Historically, when expectations are closely aligned, the actual results vary more dramatically from the projections. This is highlighted in our analysis from 2008 in Figure 2, when 8 of the 15 strategists expected returns by the S&P 500 to increase by 5% to 10%.
In the year ahead, strategists are again expecting a rosy outlook, as shown below in Figure 3. Last year, what was good was bad. Stocks often rose on weak economic numbers, which implied that the central bank would leave its zero-bound interest-rate policy in place. Can we expect to see the same things occur this year?
“Bullish on 2014” also contains projections for 10-year government bonds, operating earnings and GDP.
EARNINGS GROWTH OVERSTATED
Figure 4 below shows expectations for 2013 operating earnings, which were estimated to be about $117 per share on the S&P 500. None of the analysts expected this number, which may be because most companies did not see this growth from earnings but rather as a reduction of events.
Stock markets typically follow the trend in earnings. If we are to believe strategists’ predictions, operating earnings should rise to over $120, and the market should follow.
Improvement in earnings has come from cost cutting. Sales growth, a more persistent driver of earnings growth, only rose 2.5% over the last 21 months. This means 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 risk in projecting higher earnings growth that is realistic for the year ahead.
Analysts mentioned in Barron’s article expect GDP to increase in 2014. Nine out of 10 analysts expect GDP to increase by 2.4% to 2.9% and one analyst expects a 3.4% growth. This growth may come from companies accelerating in investments.
“In the past five years, no one was making long-term investments,” states Federated Investors’ Stephen Auth. As a result, corporations are sitting on $1 trillion of cash, and there is pent-up demand for investment around the world. Thomas Lee, the chief U.S. equity strategist at JPMorgan Chase, notes that U.S. gross fixed investment has fallen to 13% of GDP, which is on par with Greece and well below the 16% to 21% range that was obtained from 1950 to 2007.
CONSEQUENCES IN THE FACE OF PROJECTIONS
The implication for investors is that listening to strategists often leads individuals to take more of a risk than they ultimately should. Despite author Doug Short indicating in his article, “Market Valuation Overview: Yet More Expensive” that valuations are 51% to 80% above fair value, strategists are still advocating investing in the market for potential returns of over 10%.
Strategists are frequently wrong; therefore it is wise to listen to a projection only from a person who has a vested interest in the accuracy of that projection. For example, if portfolio managers Peter Lynch or Bill Gross make a projection, the results of their investments are heavily impacted by the accuracy of these forecasts.
Analysts and strategists often lack skin in dealing with the consequences if they are wrong. Projections tend to be most inaccurate at turning points and the tendency to be wrong increases when strategists have more conviction and agreement around a certain outcome, as is the case for 2014.
Lastly, with companies improving earnings from cost cutting rather than sales growth, it is a stretch to believe that growth will accelerate in 2014.