The Folly of Year-Ahead Forecasts

At the end of every year, the investment magazine Barron’s publishes a market outlook for the year ahead. It includes a survey of market strategists from leading asset managers and investment banks who provide commentary and forecasts for where they believe the S&P 500 will finish the next year.

To determine the year-end price target, each strategist develops an estimate of earnings per share (EPS) to be collectively earned in the new year by companies in the index. The strategist then assumes a price-to-earnings multiple (P/E) to apply, as follows:

EPS2020 Estimated x P/E = Year-End2020 Price Target

So how accurate are these S&P 500 forecasts?

Forecasts Missing the Mark

In 2019, they earned partial credit for a correct answer. At the end of 2018, the strategists’ average S&P 500 price target for the end of 2019 was 2975, implying a 19% price change from where the market ended in 2018. The actual price change in 2019 was 29%. While the strategists were correct in anticipating a rebound from the steep sell-off at the end of 2018, they missed the mark of actual returns by a sizable 10 percentage points.

In 2018, the group fared even worse. The consensus estimated an implied price gain of 6%. The S&P 500 actually fell 6%, leading to a miss of 12 percentage points.

“There’s no way we could have seen two cascading market corrections to end 2018,” might be the response of the group when asked why they missed the direction of returns in 2018 and about the size of the difference. They would be right, and that’s the point of this blog post.

How are the forecasting results in the long run? Are they any better?

Not really. The chart below highlights the results of this annual exercise over each of the last 10 years:

year-ahead-forecasts

Source: Standard & Poor’s, Barron’s, Clayton Wealth Partners.

At first blush, it may appear that the predictors fared much better over time. The arithmetic mean of annual returns implied by the strategists over the last 10 years was 9.2%, compared with the actual average annual gain of 11.8% calculated the same way. The difference of about 2.6 percentage points would be quite modest.

But these simple averages smooth out wide over- and under-estimates found in individual years. When using the absolute difference between forecasted and actual returns (i.e., disregarding the direction of the miss and just focusing on the magnitude of it), the forecasters were off by a much more substantial 8.5 percentage points a year, on average. Considering that average annual gains were 11.8%, that’s quite the average miss.

A Better Market Strategy

To be clear, we’re not throwing shade at Barron’s; it has earned the reputation of a quality investment publication over the past century. Nor are we criticizing those strategists that participate in the Barron’s survey; they include some of the smartest and most qualified investors around.

We do think it’s beneficial to think about what may lie ahead for the economy and markets. But to distill it into a single-point estimate, based on (a) an estimate of earnings for 500 companies over the next 12 months and (b) what market participants will feel like paying one year from now for them, in our opinion, is an exercise in false precision. So much changes throughout the year that the conditions or outlook present when the year-end targets were created are often stale in no time.

At our Topeka-based financial planning firm, our investment team doesn’t publish year-end price targets for the S&P 500. However, we do spend a lot of time thinking about market valuations, the business cycle, and investor psychology and position client portfolios accordingly.

If you’d like to learn more about our investment process or financial planning services, please reach out to us. We serve as full-time fiduciary wealth advisors at Clayton Wealth Partners, and our financial advice is focused solely on your best interests.

Contact us for a complimentary needs assessment phone call.

 

 

James Walden, CFA

As Partner and Chief Investment Officer, James Walden strives to maximize our clients’ long-term, risk-adjusted portfolio returns. This includes determining strategic and tactical asset allocations, as well as specific investment analysis and prudent rebalancing. Jim is also a partner and management team member. His expertise includes advanced investment research and valuation, and he is passionate about his role in helping clients reach and exceed their financial goals.