Market Strategists Have a Habit of Getting 'Next Year' Wrong
Tis the season for annual market forecasts.
- David Kostin of Goldman Sachs thinks the S&P 500 will finish 2018 around 2,850 (+7%).
- Mike Wilson from Morgan Stanley says 2,750 (+3%)
- Citigroup’s Tobias Levkovich—the “Eeyore” of the bunch—expects just 2,675 (i.e. flat).
Whose number will prove closest?
Before delving into forecasts for next year, let’s revisit a call from last year.
Mr. Kostin’s theme for 2017 was: “Hope, Then Fear.” In late November of 2016, he laid out a roadmap for how he thought the S&P 500 would trade going forward.
“Fear is likely to pervade during 2H and the S&P 500 will end 2017 at 2300, roughly 5% above the current level,” he wrote in his report. “Potential tariffs and uncertainty around other policy positions may raise the equity risk premium and lead to lower stock valuations in 2H.”
Yesterday, the S&P 500 ramped to a fresh all-time high, closing at 2664. The path traversed has been different than what Mr. Kostin envisioned. The S&P has registered 12 consecutive monthly gains since November 2016, and if this December closes higher, it will be the first time ever the index finishes a full calendar year without a single down month.
Policy fears may permeate the public consciousness, but they’re hard to see based on the way the market is behaving. Volatility hovers near an all-time low. We’ve gently ascended to a string of new highs, without any drawdowns over 3%.
If Kostin could go back and relabel his theme for ’17, he might title the report something like: “Easy Breezy,” or “As Good As It Gets.”
Forecasting the future is always a guessing game. Even for those who work at prestigious firms like Goldman Sachs.
2018 may ultimately be remembered for reasons we can’t even fathom right now. As we consider the range of possibilities, here is a table showing how other Wall Street strategists see next year unfolding.
The views range from flat to up 13%, with a median target of 2,825 (+6%). The consensus opinion is basically: “Up-a-Little.”
In 2017, the S&P 500 is on track to return over 15%. “Up-a-Lot” years like this one are not uncommon. In fact, U.S. stocks have produced a 15% or greater returns 27 times over the last 80 years, or about one-third of the time.
Does 2017’s gain foreshadow pain next year? Not necessarily.
In years where calendar gains exceed 15%, the stock market has finished higher the following year 70% of the time, averaging a 5.3% return (source: Bloomberg).
Applying Game Theory to Market Prediction
The annual market outlook derby is reminiscent of watching contestants battle it out on The Price Is Right. There are a lot of educated guesses, and ‘Game Theory’ often plays a role.
A few years ago, a mathematician penned an article for Slate articulating how to apply game theory to The Price is Right. “Last bidders too often rely on their intuition, or on suggestions called out by delirious audience members,” he wrote. It’s wiser to take a probabilistic approach.
Successful contestants on The Price Is Right don’t try to bid the same price as others. Rather, they survey existing bids, and take the over or under. A smart player looks for price ranges where mispriced potential resides.
You can apply similar thinking to investing, and use game theory to assimilate macro forecasts.
Consider the distribution of market forecasts a proxy for consensus expectations—i.e. what’s priced in already. Surprises are where excess returns are usually found. Thus, trying to figure out whether to take the over or under relative to consensus is a better use of your time than trying to nail a precise number for the S&P 500, or blindly following the herd.
Stocks may finish “Up-a-Little” next year, like many on Wall Street expect.
Personally, I’m taking the “under” on that view. My guess is that 2018 will be a “Down-a-Little” year.
Here are a few reasons:
• Earnings comps become a tougher hurdle next year
• Monetary policy is finally normalizing, which may cause speed bumps
• Sentiment and investor positioning are extended on the bullish side
Why not forecast “Down-a-Lot” (i.e. a decline greater than 15%)?
For starters, Down-a-Lot is rare. And I can’t pinpoint anything damaging enough on the immediate horizon to push me to take an aggressively bearish stance.
One key risk I’m monitoring is a looming credit wall. A lot of bonds in distressed sectors, like retail and energy, are due to mature. That appears more of a 2019 story, but the market may start discounting credit dislocations in 2018. To play it safe, stick to firms with pristine balance sheets.
What if I’m wrong in my 2018 view? Certainly could be. That’s why I always have counter-strategy positions in place.
As a cycle matures, I gradually nudge my portfolio up the quality scale. That means the core of my portfolio favors companies with high profit margins, strong balance sheets, and durable competitive advantages. Solid firms I am comfortable riding with into a storm.
On the other hand, I still own a mix of cyclicals and value plays. These ‘counter-strategy’ positions may do better than I anticipate, if the broad market outperforms my expectations.