A New Year’s resolution to consider: Avoid market forecasts

It’s that time of year when market gurus dust off their crystal balls and provide their “best guess” as to the direction of the stock market, commodities, and global economies.

Although such exercises have an entertainment factor, we believe they are akin to setting New Year’s resolutions as very few become realized by year-end.

We are often directed by our human nature to look for any form of control especially in volatile periods such as what has transpired over the past three years. Therefore, it is no surprise that we naturally turn to those experts often reported by the media for this artificial comfort.

The problem is that even these experts get it wrong, just ask Bill Gross at PIMCO who made a massive bet against last year’s top performing asset class – U.S. Treasuries.

Like all comfort foods, there is usually a price to be paid down the road which certainly makes it rather difficult to achieve that most common yearly resolution. The problem simply put is human behaviour is very much like the weather. Both have seasonal trends or patterns but can at times act quite irrationally with large influences on their respective environments.

We think investors are thereby better served to weather such storms by remaining focused on the longer-term fundamentals. This includes investing in quality companies trading at fair valuations while protecting against near-term risks via hedging and proven methods of diversification.

Forecasting the near-term direction of the stock market is not unlike forecasting an earthquake, tornado, or the number of hurricanes in any given year. There are simple models to complex ones, but in reality none work with any form of reasonable consistency.

Just consider last year where the U.S. lost its AAA credit rating, the European debt crisis expanded rapidly, a 9.1 magnitude earthquake/tsunami hit Japan, and social uprisings overtook the Middle East. With the exception of concerns over Europe, none of these events made the top ten lists at the beginning of last year.

Unfortunately, many in the financial industry have caught on to the selling power of forecasting. This is evident by the dominance of “buy” recommendations versus “sell” recommendations issued by sell side analysts. For example, retail stock brokers will often use their firm’s bullish recommendation and target price on a stock when selling a new secondary offering.

The problem is that analysts tend to be reactive rather than proactive with their forecasts. For example, the Bespoke Investment Group put out a very interesting summary last week highlighting how sell side analysts have been lowering their year-over-year growth estimates on the S&P 500 to 6.2% down from the 14.1% expected in September.

Analysts tend to do the same with target prices, ratcheting them down as a stock falls and increasing them as a stock increases. This is why it pays to seek out unbiased research, be diversified, and to have at least some form of hedging or risk-management strategy in place.

Many institutional money managers will for example utilize the futures and derivatives markets to employ strategies that essentially mitigate a portion of forecasting risk. In particular, those investing in the resource sector can use the futures market to hedge out all or a portion of the commodity price risk if they so choose. The derivatives market is also a useful tool to add absolute return via option income strategies or to insure against large near-term downside moves in the market.

In summary, the world economy, stock markets and commodities are quite complex and very difficult to predict especially in the near-term. Thereby don’t arrange your portfolio solely around the short-term predictions of the usual crowd of prognosticators and naval gazers.

Although they at times can provide a certain level of comfort they will very likely be invariably wrong and can be quite harmful to your portfolio’s performance.

Martin Pelletier, CFA, is a portfolio manager at TriVest Wealth Counsel Ltd., a Calgary-based private client and institutional investment management firm specializing in discretionary risk-managed balanced portfolios as well as specialty offerings including an oil & gas hedge fund.

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