The year’s batch of New Year market forecasts has been the usual source of interest. Not, obviously, because they tell you what is going to happen – the only thing we know for sure is that what is foretold will definitely not take place – but because of what the clues they give about market sentiment. However bullied, charmed or cajoled into making predictions, most professional forecasters in my experience know full well that the value of their forecasts is at nugatory at best.
The latest annual forecasting round also, as ever, provides fresh opportunities for pundits to twist and torture the English language into confessing to apparent certainties that in practice have little or no meaning. One perennial favourite – much in evidence again this time round – is that the year ahead will be a “year of two halves”. I suppose there may come a time when this won’t be the case, but for the moment I choose to count this as stale news.
More prosaic, and more commonplace, are the well-worn observations that financial markets will continue to be volatile this year, that periods of weakness in asset prices will be followed by rallies, and that “considerable risks” remain, all “true but trite”. Such statements tend to confirm J.K.Galbraith‘s lapidary statement that forecasters forecast “not because they know, but because they are asked”.
This year again, very much true to form, the consensus view seems to have coalesced around the view that the US equity market will finish the year around 8%-10% higher than it started. Taking “Siegel’s constant” and adding somewhere between 2% and 4% for inflation, huddling around the long run average is the default option for any equity market forecast. While that seems a low-risk approach, it ignores the uncomfortable truth that the stock market more often than not fails to produce an average return in any given calendar year.
In fact, more than half the time the outcome is a movement of more than 20% in one direction or the other. The remarkable thing about the US stock market’s performance is that it finished the year almost exactly where it started, which is a very rare occurrence historically. A more sceptical interpretation of the consensus forecast is that it simply says “I have no real idea what is going to happen, so I am going to extrapolate and hope for the best”.
James Montier, a strategist at GMO, has helpfully explained on many occasions how poorly grounded in reality the forecasts of analysts at broking firms tend to be. In his annual survey of economic forecasters this year, David Smith of the Sunday Times reported new levels of inadequacy in 2011, with less than a handful of the country’s pre-eminent economic forecasters scoring more than half marks in their prognostications for five key economic indicators. Even the best forecaster only managed a miserable score of six out of ten.
Time and again, in my experience, the most pragmatic technique with forecasts is to log them into ranges on a histogram and plump for one of the outcomes that has not been identified by a single one of the surveyed participants. For many years that worked very well in the bond market, for example, and its track record with equities is miles better than the consensus. On that basis will 2012 turn out to be the year that the Eurozone crisis turns out to be the Millennium Bug of the new decade – a widely forecast disaster that turns out not be the catastrophe which many had confidently predicted?
It is not impossible. For one thing, it surely cannot be said that the risks of a Eurozone meltdown are not now fully in the market, so even modest signs of light as the endgame approaches can prompt a marked rally. It has been striking how quickly investor appetite for risk appears to have returned in the last few weeks. The balance of bulls versus bears in the AAII survey of investor sentiment in the United States, for example, has touched its highest point for more than 20 years, excepting only the same period a year ago. The VIX has also fallen back sharply.
The contrast between dire media headlines, which have remained almost uniformly negative, and the positive market reaction has not been this marked for a fair while, although safe haven assets such as AAA sovereigns (such that remain) have also, paradoxically, started the year brightly. The key to this conundrum no doubt lies in the heightened volatility of all these series and the highly unusual, bipolar nature of the current economic backcloth, which, as has been pointed out here before, is distorting many traditional indicators and making investment management more than normally tricky.
In practice only marginally more confidence can be placed in the market’s recent sunnier outlook than in the earlier predictions of imminent disaster. Although the outlines of an interim solution appear to be taking shape, the endgame of the Eurozone crisis is still impossible to call with any great certainty. Last week, while the Greek debt talks approached a denouement, Portugal was also coming under the bond market cosh. History does tell us though that what comes to dominate the way that the market behaves in the coming months will most likely be some other event of which we have not inkling at this moment, just as the Arab Spring, and the Japanese nuclear disaster, were not on any investor’s radar this time last year – or indeed in many New Year forecasts.
Jonathan Davis 