Beware of Strategists Bearing Gifts
Dunn Warren Investment Advisors
By Jamie Cornehlsen
January 27, 2012
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This time of year Investment Strategists are rampant with projections for the year ahead return. Beware; these “gifts” are more often than not just a lump of coal.
In 2005 I started tracking the projections analysts provided to Barron’s. I did this based on an article from Ken Fisher in Forbes Magazine, who stated that analysts are seldom accurate in his projections. How right he was.
Since I began measuring the accuracy of the analysts’ projections in 2005, only two out of the past six years did a majority of the analysts correctly project returns (in 2007 and 2009). All the other years the investment strategists were off the mark. See the Appendix for the historical analysis from 2005 to 2010
2011 was no different. It makes you ask why these strategists are even paid in the first place. Ten analysts made projections in Barron’s at the end of 2010, for 2011.
Only one strategist accurately projected a return of 0% to 5%. One strategist expected a decline. Three strategists expected returns between 5 and 10%. Half of the strategists expected a return of 10% to 15%. What causes analysts to be off the mark? I believe it is due to a faulty process.
Typically the strategist’s process is to estimate earnings a year in advance and then apply a multiple on those earnings. Whether an optimistic bias or an eagerness to have investors buy into the market, the strategists assume a continuation of the trend. Vitaliy Katsenelson, CFA, Chief Investment Officer at Investment Management Associates, Inc (IMA),has provided research that earnings seldom follow a steady course. Rather earnings fall victim to regression to the mean because as a good thing becomes known, competition erodes profit margins over time. Rather than account for receding margins, strategists keep profit margins high. This regression to the mean can be seen in the graph below.
The S&P 500 is a non traded index of companies compiled by Standard and Poor’s. The reported Earnings represent the earnings of the companies in the index. An investment cannot be made directly into an index
The dark blue line shows actual reported earnings, while the yellow line shows cyclically adjusted earnings that grow at a consistent 6%. There are times when earnings grew above the trend as well as times when earnings fell below the trend.
The second reason for poor earnings forecasts is the use of forward looking valuation measures, rather than adjusting earnings over a full market cycle. This latter process was first popularized by Benjamin Graham in Securities Analysis, and recently espoused by Professor Robert Shiller.
Doug Short provides a good analysis of cyclically adjusted price to earnings in his article at http://advisorperspectives.com/dshort/updates/Market-Valuation-Overview.php
With current valuations almost 30% above fair value based on cyclically adjusted price to earnings, the risk to projected returns in the year ahead is high.
This past year, only one strategist correctly predicted returns between 0% and 5%.
Eight strategists expected returns of 5% or more. The misstep seemed to occur in expecting a higher valuation. Earnings increased, but valuations paid on those earnings actually declined as earnings grew.
Ken Fisher advocated looking at what the majority of strategists were projecting and chose the opposite. As we move into 2012, most analysts are projecting a return between 5% and 15%.
No analysts are projecting returns in the low single digits. Two analysts expect returns to decline. Based on Ken Fisher’s strategy, expecting 0% to 5% returns or a decline in value may be the more accurate projection.
Jamie Cornehlsen, CFA is founder and portfolio manager of Dunn Warren Investment Advisors, as well as co-author of Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends. Jamie is the Co-portfolio Manager of the CIFG Max-balanced fund. To learn more about the portfolios managed by Dunn Warren or listen to their monthly call visit www.dunnwarren.com
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