inside the market

The editors here at Report on Business have asked for a "Year Ahead" set of equity market forecasts and I welcome the challenge and enjoy the process. With this column, let's take a look at two potential scenarios that highlight both why the plethora of sell-side market outlook reports and mine are likely to be inaccurate – and also why investors should read as many credible versions of them as possible despite this fact.

Scenario No. 1: A prominent Goldman Sachs analyst sees a 65-per-cent probability that her top-pick stock will generate outsized 2016 earnings growth of \$1.80 per share, a 30-per-cent improvement over 2015's (again hypothetical) \$1.38 per share. The analyst also predicts an 80-per-cent probability that the stock's price-to-earnings ratio will remain the same at 15 times trailing earnings. All of these expectations combined lead to a potential investment return of 34 per cent.

Simple probability math makes the likelihood of this scenario easy to calculate: Just multiply the odds of 30-per-cent earnings growth by the probability of a stable P/E ratio. So 0.65 times 0.8 gives 0.52 – a 52-per-cent chance things will play out exactly as the analyst expects. Barely better than a coin toss. (In the normal course of investing, analysts will not provide probabilities as in our hypothetical scenario. I strongly suggest investors apply their own to the best of their abilities. For a broader explanation of this practice, Michael Mauboussin's Decision-Making for Investors has been my pick as the absolute, single best report for investors to read.)

The analyst's forecast provided investors with a potential 34-per-cent return that is a pretty much a 50/50 proposition. So how useful is this? I would argue that it is useful for two reasons. One, the optimism on the company, which is usually supported by considerable analysis, is notable as grounds for further investor research. Two, the predictions could be wrong for happy reasons – growth could be better than 30 per cent and P/E multiples could increase, providing even higher returns.

Scenario No. 2: This scenario is far less hypothetical and applies to the forecaster, not investors. In my case, if I made a list of the top 10 concerns I had about U.S. markets, the potential for rising wages to cut into extremely high current corporate profit margins would be on it. The possibility that the strong U.S. dollar would squash a nascent U.S. economic recovery (U.S. goods becoming so expensive for foreigners that business activity slows) would also be on the list.

Here's the dilemma: It's incoherent to be worried about both of these risks in a year-ahead report because they are largely mutually exclusive. It's very unlikely that both strong wage growth and a weaker U.S. economy will happen at the same time. I have to pick one, otherwise the forecast looks like, "the two biggest risks for U.S. equity markets are that the economy will speed up and that it will slow down."

Choosing which of these two risks is the most pressing determines the content for the rest of the predictions for next year. If labour costs are more likely to derail U.S. corporate earnings, this leads to a strong forecast for the U.S. economy. Higher wages would lead to higher spending, and American growth is still driven primarily by the consumer. Retail stocks would look great.

Deciding that the strong U.S. dollar and slowing growth in the emerging markets will result in the U.S. economy disappointing optimistic forecasts leads to an entirely opposite set of predictions. Bonds and dividend-paying equities would continue to outperform economically cyclical stocks. Homebuilder stocks would look vulnerable, investor risk tolerance would likely decline.

In this way, forecasting is "path dependent." Once one or two big decisions are made, the rest becomes obvious. But what would happen if I were worried equally about wages and the effect of the strong greenback on U.S. exports? Thankfully, I am more concerned about wages, but a new series of data points could change my mind at any time.

The path dependency of forecasting is a good reason investors should read a number of market outlooks with differing opinions. Strategists and economists can be forced, by pure logic, into a set of predictions in which they are far less confident than it appears. Only by reading widely differing views can investors make a reasonable assessment of which set of predictions make the most compelling argument to them.

Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online.