Looking for Positivity on the Markets? Don't Hold Your Breath

Morningstar

A high-profile weatherman in Chicago is well regarded in meteorology-geek circles, but he's also well known for being overly pessimistic in his forecasts. When this particular meteorologist is predicting a foot and a half of snow followed by negative temperatures, as he was this past week, I know that we'll have a decent amount of snow and cold temps, but that the bad weather won't rise to the level of his gloomy forecasts.

So why does this forecaster continue to be venerated for his accuracy? I'll hazard a guess. If you get people geared up for poor weather that doesn't materialize, no harm done: Who's going to complain if they unnecessarily pulled out the heavy-duty boots or planned on a longer commute than usual but ended up getting to work early? On the flipside, if bad weather does happen and you helped people prepare for the misery, both physically and psychologically, you're a hero.

Positivity = Career Risk
There's a similar phenomenon at work when it comes to forecasting the market's direction. Negative forecasts abound, but positive outlooks tend to be few and far between, perma-bull Jeremy Siegel notwithstanding. And yet, over time, stocks tend to beat all other asset classes. And in some years, like 2013, stocks beat most experts' predictions by an enormous margin

The rationale behind all the gloom is similar to the weather forecasters'. Numerous behavioral finance studies have demonstrated that people tend to experience the pain of losses more acutely than they do the euphoria of gains. If market prognosticators are overly sanguine and people who follow their lead lose money, the clients won't readily forget it, and may even fire them. (Of course, not all of the pessimism is rooted in self-preservation, as the math of losses is ugly: If investors lose 50% of their money, they'll need to gain 100% to get back to where they started.) Meanwhile, opportunity cost--the money that clients could have made but didn't--isn't as visceral. That means if you're a forecaster, the career risk of being pessimistic and wrong is much less than incorrectly being too optimistic.

And for those inclined to seize upon them, there's never any shortage of worrisome headlines. Coming into last year, for example, naysayers could point to a hopelessly gridlocked Washington situation, slowing growth in emerging markets, and not-cheap valuations as potential headwinds for stocks in 2013. Add in the still-fresh memories of the twin bear markets in the early 2000s and 2007-2009, and it's hard to blame anyone for sounding a cautionary note.

Thus, it's not surprising that few market watchers were pounding the table for stocks as 2013 dawned, even though stocks were poised to post their best annual gain in 18 years. A panel of Wall Street experts surveyed by Barron's in late 2012 anticipated an average S&P 500 gain of 9.5%. That prediction was, of course, directionally correct, but it was more than 20 percentage points behind the S&P's actual gain. The bullish forecaster of the bunch predicted a 14% gain for the market, while one of the forecasters predicted a loss.

Morningstar readers were also pretty 'meh' on stocks' prospects when I surveyed them at the outset of last year; the mean prediction for U.S. equities was 9.3%. Morningstar's own Market Fair Value graph showed the stocks in our coverage universe as just a hair undervalued coming into 2013.

Other market experts were even less optimistic. The venerable Jeremy Grantham opined to Forbes' Matt Schifrin that 2013 would be "a dangerous year" for stocks. Research Affiliates' Rob Arnott was similarly pessimistic on U.S. equities in early 2013. Arnott's free-roaming PIMCO fund, PIMCO All Asset All Authority (PAUAX), paid a heavy price for that pessimism last year, losing more than 5%.

Factors Beyond Our Control
That's not to suggest that acclaimed investors have completely missed the boat on predicting the market's ascent. During the height of the financial crisis in late 2008, for example, Warren Buffett famously urged investors to buy U.S. stocks--a call that, while early, paid off handsomely over the next five years. Morningstar's Market Fair Value graph was also flashing a strong buy signal around that same time.

And in any case, it's hard to fault market watchers who ground their forecasts in the only factors that can be measured and forecasted with any degree of accuracy: whether companies are, in aggregate, trading cheaply or dearly relative to their profits, cash flows, and other measures of what the businesses are worth. Given that cheap valuations are the best predictor of market performance and rich ones the most predictive of corrections, we're all wise to listen up when prognosticators say that markets are excessively cheap or expensive based on those factors. At big market inflection points when the stock market or individual sectors look ridiculously cheap or dear--such as in late 2008/early 2009 or when tech stocks were scaling ridiculous heights in the late 1990s--experts' calls have been quite prescient.

But sometimes, as in 2013, the market moves up for reasons that go beyond what business fundamentals would suggest, and those exogenous factors and their impact can be devilishly difficult to predict. While cheap valuations were the key catalysts of the early part of this rally--in 2009 and 2010--in 2013 one of the biggest boosts to stocks was probably the dearth of attractive alternatives. The Federal Reserve's polices pushed down yields on cash and high-quality bonds to such low levels that investors in search of a decent return on their money had little choice but to be invested in stocks. As a result, assets sloshed into equities and out of cash and bonds throughout the year, pushing up stock prices.

Valuation-conscious investors often dismiss such momentum-driven rallies, correctly arguing that "me too" market participants inevitably overshoot on the downside as well as on the upside. But at least part of 2013's rally was driven by improvement in real business fundamentals. Indeed, improving corporate profitability helps explain why Morningstar's price/fair value for the stocks in its coverage universe is not too far from where it was at the outset of 2013, despite a 30% increase in the stock market.

What Does It Mean?
All of this is not to suggest that investors ignore market prognostications across the board; they can carry valuable intelligence. If there's a groundswell of optimism or pessimism on the market, or a market sector, owing to valuation considerations, that ought to serve as a catalyst--or give you pause--before putting a large sum of new money to work at that point in time. If you're already invested, having a sense of whether the market is over- or undervalued may help you set better expectations and forestall the poorly timed investment decisions that can accompany whipsaw markets.

In most situations, however, investors would do well to stick with a handful of truisms when managing their portfolios: that stocks are likely to outperform other asset classes over time and that there will be significant volatility along the way, with stocks periodically becoming too cheap or too dear. For my money, the tried-and-true advice of buying, holding, and rebalancing addresses those issues in a more elegant and disciplined way than paying attention to short-term market calls ever will.

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