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Financial market forecasting is difficult but not futile. image of target with arrows on blue background
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Financial market forecasting is difficult but not futile

24th January, 2022

Published in The Sunday Times on January 23rd 2022

There’s an old Wall Street maxim about stock market predictions: forecast a number or a date, never both. It’s an aphorism that the authors of a book called “Dow 36,000, The New Strategy for Profiting from the Coming Rise in the Stock Market.” would dearly love to have taken heed of. The authors, James K. Glassman and Kevin Hassett can take a bow – the Dow Jones hit their target a couple of months ago (November 2021). Sadly for them, that was more than 22 years after the book was published in October 1999, when the Dow closed at 10,273. The journey took slightly longer than the three to five years they had predicted. The book has been labelled the "most spectacularly wrong investing book ever." 

I think that’s very harsh. I’m certain there are other spectacularly poor investment books – but that’s not my point. The book’s central message was sound, but opinion in relation to it was hijacked by the attention seeking title they chose for it. 

The underappreciated message of the book which has aged much better is: if you buy and hold a broad range of stocks for a long period of time, you'll do exceptionally well. Had an investor bought the Dow Jones at the end of 1999 and reinvested dividends, $10,000 would now be worth approximately $50,000.

The authors were well-credentialed professionals. Their thesis was not without merit. According to Glassman, over the three quarters of a century prior to publication, stocks had returned an annual average of about 11% and government bonds 5.5%. Yet over the long run, stocks were no more risky than bonds – they had never delivered a negative real return over periods lasting 17 years or more as outlined by Jeremy Siegel.

In other words, stocks carried a big premium compared with bonds to compensate investors for the extra risk they were taking, but according to the authors – there was no extra risk! Their belief was that people would bid up the prices of stocks.

The paradox they identified is called the equity premium puzzle. Why have equities historically returned so much more than bonds? Higher prices today mean lower future returns – this would bring the two asset classes into the proper equilibrium that the authors argued. People are afraid of investing in the stock market. Predicting people would lose their fear of stocks and act rationally was naive at best. Many a financial market forecast has run aground predicting a change in human behaviour. 

Apart from the futility of financial market forecasting, there are two issues here worth highlighting.

Firstly, when we (those of us that provide financial market commentary and opinion) refer to the extraordinary returns to equity investors over the long term, we are usually referring to the US stock market. Using the most successful capitalist system in the world as the basis for claims about future expected returns is subject to survivorship bias. Both the Chinese and Russian stock markets have broken histories in the 20th Century, where even long term investors would have been wiped out. The median return when looking globally has been far lower than that generated by the US. We should bear this in mind more often when making claims about future returns.

The second point relates to risk and perceptions of it. 

Financial risk is defined as the volatility of the value of an asset – the extremes of its ups and downs. Over 20-year periods or more, stocks have displayed remarkably consistent returns – with no losses even after taking inflation into account, as outlined previously. It is for this very reason I have used numerous column inches in this publication (The Sunday Times) to argue that risk is more appropriately thought of as failure to meet realistic expectations rather than short-term capital loss or volatility. 

But investors have perceived overall risks to be higher because, in the short term, awful things can happen – as many awful things have in the last 22 years. Predicting that the gap in returns between stocks and bonds would quickly vanish was silly. It was akin to saying an investor today would be indifferent to an Irish Government 10-year bond yielding 0.3% and a diversified stock portfolio with the same expected total return. I certainly wouldn’t be. 

That’s why an equity premium exists. We need to be compensated for the inevitable uncertainty. For investors today, with a long view and staying power it means you can expect higher returns from equities than bonds in the future. The Dow 36,000 book’s central message remains intact. That may be faint praise for stocks, given that has always been the case. 

If you are looking for a more definitive prediction you’ll need to consult Messrs Glassman and Hassett. 

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