The only sure way to make market forecasts that have any enduring value, I have learnt, is to follow the formula successfully deployed by Sir John Templeton. His technique was to look a fair way ahead and come up with a number that sounded impressively large – impressively large, that is, until you examined his assumptions and worked out what compound rate of return his forecast actually implied.
So for example with the Dow Jones Industrial Average at around 800 in 1980, having convinced himself that stocks were cheap, he boldly predicted that the market could reach 3,000 before the end of that decade, and could easily rise 20 fold by 2020. That sounded extraordinary at the time to a generation which had just survived the 1974-75 bear market.
Yet in practice, given his premise that inflation would continue to double the price level every ten years, the 3,000 figure represented a real compound rate of growth (after inflation) of 8% per annum. That was certainly some way above the long term average growth rate for US equities, as the historical average is a total return calculation.
But given that starting valuations in 1980 were already very depressed by historical standards, the headline-grabbing forecast was nothing like as wild as it might at first have appeared. For the Dow to reach 16,000 by 2020 from its current level of around 10,500, incidentally, it will need to rise at a compound rate of 4.5% per annum for the next ten years – so even though inflation has fallen dramatically in the interim, the original 1980 forecast is still by no means an unlikely target.
For good measure, although Templeton liked to give a specific end point to any forecast he made, he was too smart to commit himself more directly to when his target might be reached, leaving plenty of room for relapses and consolidations along the way. (A more cynical version of this approach to forecasting was summed up by the economist who said “if you have to forecast at all, forecast long and forecast often”).
What Templeton was however was a self-confessed optimist, who continued to believe right up until his death that, while the market would continue to suffer periodic setbacks of 30%-50%, those who predicted a new Great Depression were wrong. He had great faith in the hunger and resilience of the American people and in the capacity of humankind to make progress. Market setbacks were the price you paid for long term equity returns.
For example, in 1987, with what turned out to be uncanny prescience, Templeton said that he fully expected an imminent fall of 30%-50% in the market. It duly happened, but within weeks of Black Monday in October of that year he was reiterating his arguments about the Dow reaching 3,000, and celebrating the fact that investors had been given a second chance to get in on the ground floor of what he remained convinced would prove to be one of the greatest bull markets of all time.
The following year he became bolder still. His study of market history over many years had convinced him that bear markets rarely last longer than 15 months. If markets have not breached their previous low within 12 months, he argued, the odds are very high that they won’t go on to do so again. (If that assumption still holds, it makes it virtually certain that a new test of the March 2009 bear market lows is unlikely this time round).
Speaking in 1988, Templeton discounted the prevailing fears of doomsters of the day, arguing that all the major problems that preoccupied the markets at the time were already known and consequently priced in. “The fact that we have a terribly unbalanced federal budget” he told one interviewer “is already in share prices. The fact that we have a bad balance of payments in foreign trade is already reflected in share prices”.
It was wrong to assume that trade or budget deficits would lead to either depression or deflation. Anyone who studied financial history, he believed, would see that large budget and trade deficits only ever resulted in inflation. By the same token, like many of his generation, he was confident that politicians had learned the lessons of the Great Depression and would never allow the economy to slip into deflation.
Would he still think the same way today? He is not around to tell us, but close analysis of his thinking over many years suggests to me that notwithstanding the unprecedented scale of the global financial crisis, he would be on the bullish side of the consensus. Having clearly identified the severity of the looming housing market bubble five years ago, and seen the market tumble by 50% from its peak, I don’t think he would be betting against the resilience of the US economy now.
It is easy to be daunted by the enormity of the task that lies ahead. Where is the political will to eliminate the extraordinary pile of public sector debt that the crisis has engendered? Where will the jobs come from? How can future banking crises be averted if the banking lobby succeeds in blocking the reintroduction of a badly needed modern version of the Glass-Steagall Act?
We don’t know. Nothing can be ruled out absolutely. But without falling into the trap of making a specific year ahead forecast, the odds still surely favour the Dow making Templeton’s target of 16,000 before 2020 a very reasonable bet.