We’d be entering 2015 in just a few more days and this is a time when you’d see the financial media start pumping out outlooks that financial experts have for the upcoming year and how investors should invest. But even if the experts do sound convincing and logical with their forecasts, they might still all be making big mistakes – and that’s why investors have to beware. Local forecasts, global mistakes Singapore’s national weekly broadside The Sunday Times had just published an article on Sunday on the investing landscape for 2015 titled “Investing tips and trends for the new year.”…
We’d be entering 2015 in just a few more days and this is a time when you’d see the financial media start pumping out outlooks that financial experts have for the upcoming year and how investors should invest. But even if the experts do sound convincing and logical with their forecasts, they might still all be making big mistakes – and that’s why investors have to beware.
Local forecasts, global mistakes
Singapore’s national weekly broadside The Sunday Times had just published an article on Sunday on the investing landscape for 2015 titled “Investing tips and trends for the new year.” A bunch of experts had a round-table discussion with The Sunday Times recently, and the paper had reported on what was discussed. Here’re some choice excerpts:
1. Gross Domestic Product (GDP) growth in the U.S. came in at 5% in the third quarter of 2014, an unexpectedly high figure and the strongest it’s been for the country in over a decade. According to The Sunday Times, “this means that stocks that benefit from stronger consumer spending in the US could be a good buy, says Mr Lennie Lim, regional head for Asia at fund manager Legg Mason Global Asset Management.”
2. The paper then followed up by quoting Lim directly: “We are rather optimistic in terms of continued economic growth, especially with regard to the US economy. And given its strong consumption attributes, I think that will translate very well into strong corporate earnings.”
3. DBS‘s chief investment officer, Lim Say Boon, was quoted by The Sunday Times: “There are definitely winners in the local stock market – those who benefit from stronger US consumption, lower oil prices, eventual recovery of China growth.”
The three statements above were picked out because – despite being logical and rational – I think they highlight two very important issues with regard to investors who depend on forecasts to invest.
The first big issue
Let’s start with the first issue which is seen in the first and third excerpt. On a broad level, both seem to display the mistake of being too sure of “if A, then B.” But like investor Howard Marks once said, “One thing you can never be sure of in the investment world is <<if A, then B>>. Processes and linkages are not always predictable.”
For some concrete examples of the dangers of thinking that A will lead straight to B, here’re some fantastic ones taken from a recent article titled “Pandering Your Wealth Away” by my colleague Morgan Housel:
“During the 1992 [U.S. presidential] election, a popular argument was that Bill Clinton’s proposed remake of the U.S. healthcare system would be disastrous for pharmaceutical stocks. “What has clouded their appeal for many investors lately has been the prospect of major political change for health-care businesses, especially if Gov. Bill Clinton wins the presidential election next month,” the Santa Cruz Sentinel wrote in Oct. 1992.
The overhaul never happened, and by the end of Clinton’s presidency pharmaceutical companies were some of the most valuable companies in the world. Pfizer increased 791% during Clinton’s presidency. Amgen surged 611%. Johnson & Johnson popped 385%. Merck jumped 299%. Those crushed the market, with the S&P 500 rising 251% from January 1993 to January 2001.”
“During the 1996 election, pundits pointed to a powerful historical trend. “Studies have shown that small stocks usually fare better under Democratic administrations and bigger stocks fare better under the Republicans,” the News Tribune wrote. “So, the message is clear: If Bill Clinton wins, think small; if Bob Dole wins, think big.” Clinton won, but the opposite trend took place. From 1996 to 2000, the small-cap Russell 2000 rose 54% while the large-cap S&P 500 jumped 131%.””
“During the 2000 election, Newsweek wrote that if George W. Bush wins, the ensuing tax changes could “help banks, brokers and other investment firms.” By the end of Bush’s second term, the KBW Bank Index had dropped almost 80%.
The article also recommended pharmaceutical stocks thanks to Bush’s light touch on regulation. The NYSE Pharmaceutical Index lost nearly half its value during Bush’s presidency. Another popular piece of advice was to purchase airline stocks if Bush won, because “a broad tax cut … has the tendency to increase discretionary spending,” as one analyst put it. By 2005, four of the six largest U.S. airlines were bankrupt.”
Morgan’s intention in his article – as is mine in here – is not to poke fun at pundits. Instead, it’s to point out that predictions can seem to make great sense, but yet can still turn out to be dead wrong. And investors who invest based on these predictions would end up suffering for it.
The second issue
The second issue here is found in the second excerpt and it is about the fundamental error of thinking that near-term corporate growth would lead to commensurate share price gains. Morgan once quipped that “the single largest variable that affects returns is valuation – and you have no idea what they’ll do.”
For stocks, future returns are really only governed by three factors: Earnings growth, dividend yields, and changes in a stock’s valuation (in other words, its price/earnings ratio). The first two factors could reasonably be predicted within a comfortable range. But the third factor – the earnings multiple – is hard to fathom. Here’s how Morgan describes it:
“Earnings multiples reflect people’s feelings about the future. And there’s just no way to know what people are going to think about the future in the future. How could you?
If someone said, “I think most people will be in a 10% better mood in the year 2023,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.”
Rig builder and property developer Keppel Corporation Limited (SGX: BN4) is a great example of how sudden changes in investor psychology can overwhelm corporate growth. A year ago on 28 December 2013, the company was earning S$0.988 per share and priced at S$11.18, meaning to say it had a PE ratio of 11.3. Back then, hardly anyone would have expected investors to be in a 25% “worse” mood one year later.
But today, because of the recent collapse in oil prices, investor psychology has turned, causing Keppel’s share price and PE ratio to decline to S$8.75 and 8.6 (the PE ratio has declined by almost a quarter), respectively. This has happened despite the company’s earnings per share actually growing by 3% to S$1.017.
A Fool’s take
Predictions in the financial markets are often wrong (especially short-term ones), regardless of how logical they might seem when they’re first made. For this reason, a prudent – and more satisfying – course for investing might be to stick with what works. And that is, to buy great companies and hold them for the long-term (for those who have the interest and ability to spot them), or buying and holding low-cost funds tracking broad market indexes (for those who really do not have much interest in individual stock picking).
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.