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Man with a telescope (windcatcher/Getty Images/iStockphoto)
Man with a telescope (windcatcher/Getty Images/iStockphoto)

How reliable is the stock market when predicting the future? Add to ...

I had the pleasure of dining with a group of friends recently at one of the fine wineries along Lake Erie. Near the entrance was a rock hanging from a chain, known as a “weather rock.” One of our friends explained how it works. When it’s wet, there is rain. When it’s white, it’s snowing. And when it’s swinging, it’s windy.

More from Dan Hallett

Noting that it’s easy to predict the past, another astute member of our group asked if my HighView partners and I were good at financial predictions. I remarked that we’re definitely better than the weather rock. This reminded me that forecasting is an ironic and humbling exercise. The irony: short-term predictions are notoriously more difficult than longer-term forecasts.

When asked for shorter-term predictions, I respond candidly that I can guess what’s going to happen from year to year, but I don’t know for sure. Nobody does despite the proliferation of forecasts that our industry produces. And stock market returns from the past several years illustrate this nicely.

Correct prediction; unforeseen result

Recall that the U.S. housing market was the first in a long line of economic dominoes that launched the global financial crisis. Some who predicted this – and there were a few – assumed that U.S. stocks would feel the brunt of the stock market pain and that investors would trip over themselves to dump their U.S. Treasuries.

But the opposite happened. U.S. stocks lost less than most other stock markets and the U.S. dollar soared in value – and pulled up Treasuries with it.

Stock market quiz: economy versus stock market

Here’s a short quiz to test your more recent memories. Which of the following regions boasted the highest stock market performance in calendar 2012 – Europe, North America, Asia-Pacific or emerging markets?

Many are surprised to learn that stock markets in rapidly growing emerging markets (up 16 per cent) and recovering North America (up 13 per cent) trailed far behind Europe’s 20-per-cent stock market performance in 2012 despite the region’s limping economies. Greece, by the way, was one of the top performers with a sizzling return of 25 per cent – the sixth best among European markets. (All returns are in Canadian dollar terms.)

But not every year’s performance is in sharp contrast to the stories of the day. China’s slowing economy in 2013 has aligned with its year-to-date flat stock market performance (when measured in loonies). And the continuing U.S. recovery has been met with a 27-per-cent YTD gain through July 26. But there are always surprises.

Ireland’s economy has shrunk a bit year-over-year while its stock market has modestly outpaced the strong U.S. market this year. Two divergent economic stories but nearly identical stock market returns.

Italian stocks are up more than 8 per cent this year (in Canadian dollars) despite high unemployment, a shrinking economy and a sky-high debt load, illustrating that year-to-year returns are unpredictable and not always tied to what’s happening in an economy.

When returns are seemingly illogical, price sometimes plays a key role in explaining a market’s returns. Indeed, price is a key driver of our longer-term return forecasts.

Longer-term forecasts

Every financial adviser has to take each client through at least a basic discovery process to understand how each client accumulated their wealth and what they want it to accomplish for them. Accordingly, when an adviser recommends a portfolio to a client, there is an implicit expectation for the portfolio to return at least the client's target return with an acceptable level of risk. Some form of return forecast is required to have comfort and confidence in the recommended portfolio.

Our forecasts blend history with common sense and forward-looking judgment calls, drawing on current valuation, expected earnings growth and the expected change in valuation. More investors and advisers should widen their focus beyond the more recent past.

Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com.

 

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