Warning: Wall Street can’t predict where the S&P 500 will go in 2017
Every December you can expect analysts at large banks to issue year-ahead forecasts for the S&P 500, but only about a fifth of them will be on the mark in any given year.
In fact, studies show a novice could guess the target with the same accuracy, or inaccuracy as it were, as large banks.
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This begs a question: How useful are such forecasts and do investors benefit from them?
The most typical prediction among leading banks for the S&P 500 SPX, +0.03% is based on two hard assumptions: projected earnings for the next year and what multiple investors are likely to pay for those earnings. So, for example, multiplying a projected $130 earnings per share by a price-to-earnings ratio of 18 equals a projected level for the index of 2,340.
Different analysts arrive at both assumptions by different routes. Some use bottom-up EPS, derived by aggregating consensus estimates for each stock on the S&P 500. Some take a top-down approach, by guessing a growth rate from the previous year. Some take a number somewhere in between the bottom-up and top-down estimates.
The multiple that investors are willing to pay in the future is essentially a guesstimate, as even investors themselves do not know how they will feel a year from now.
“We look at what investors had paid so far and extrapolate what they might pay in future. But it’s truly a wild card. Multiple expansion and multiple contraction for no good reason can and does happen,” said Karyn Cavanaugh, senior market strategist at Voya Financial.
Cavanaugh is among market strategists who issue outlooks with specific targets for the S&P 500, but she cautions that these forecasts should be taken as a guideline, not as a rule.
“Forecasts that say the S&P 500 will be at a certain target is a way to tell investors to stay invested in the market,” said Cavanaugh.
The fundamental analysis and trends that people can spot in data has a great value of explaining the current situation, but rarely results in accurate market predictions, according to Star Capital, Germany-based asset manager, which stressed that banks’ forecasts are almost always positive.
“Banks’ forecasts are not more precise than assuming a constant yearly stock market return of 9%. This result remains true for every arbitrarily chosen return between 7% and 19%,” said Star Capital, as shown in the following chart.
“Taken into account that the average error of analysts’ 12-month forward EPS forecasts since 1973 is 30%, nearly any company value — and hence any stock value — could be justified based on discounted cash flow models,” they said, in a note. “Thus, we avoid predicting short-term earnings.”
Finally, they present a chart that shows a possible range for the S&P 500 based on the last 130 years of a comparable valuation and returns during the subsequent 15 years.
Based on the historical experience, there is an 80% chance the S&P 500 will trade between 2,500 and 9,200 points in 2031 and 50% chance it will trade between 3,200 and 6,100 points.
Shorter term, it’s likely that the S&P 500 could be trading anywhere between 1,500 to 4,100 over the next three years, according to Star Capital.
This chart basically means that guessing where the S&P 500 will be by the end of the next year is just that: a guess.
Even if you have a good grasp of where interest rates, the dollar, oil prices and monetary or fiscal policies round the globe could stand, and you can foresee all geopolitical risks, your chances of accurately predicting investors’ collective behavior are rather slim.
So, if banks miss their own forecasts all the time, why do they still bother predicting markets?
Seemingly, because people still want them, according to Ben Carlson, director of institutional asset management at Ritholtz Wealth Management LLC.
“The worst kind of forecast is the binary one, like ‘sell everything’ or ‘buy everything’ types of calls,” Carlson said.
“But the forecasts that give you a base rate and a range of outcomes is probably a lot more useful for making decisions on allocations,” he said.
While sell-side analysts almost always miss their own forecasts, investing in stocks based on their buy or sell recommendation is unfruitful, according to a study by Intertrader, U.K.-based spread betting firm.
The firm built a model portfolio of a “hot” stocks in 2015, buying and holding a given listing following a buy recommendation.
Such a strategy would on average net an investor a mere 0.8% annual gain before transaction costs, which would make leaving the same money in a bank for a year, assuming a 3% return, appear to be the safer bet.
Ritholtz’s Carlson suggested that investors always prepare for a range of outcomes based on where the markets are at any given point in time.
“Investors should look at their portfolio and ask ‘How will my portfolio perform under such and such scenario and what are the probabilities of that happening?’ In fact, how you are allocated, in a way, is a forecast,” he said.
Originally published at www.marketwatch.com on December 6, 2016.