10.2% Prediction for U.S. Market Next Year

Last week someone showed me a USA Today article where they rounded up the usual suspects who weighed in with their 2011 market predictions. I don’t have the article in front of me but the Chief Investment Strategists for Blackrock, Goldman Sachs, and other massive institutional investors fearlessly jumped in with their predictions. What surprised me (I don’t know why this kind of thing should surprise me anymore) was the specificity of the forecasts. Many of them gave their predictions down to the level of tenths of a percent. The more I think of it, if you are willing to go out on a limb and say the Dow Jones Industrial Average is going to gain 10% next year, then why not make it 10.1%? The extra ten basis points makes your forecast more persuasive since it implies greater scientific rigor in coming up with the number. Many of the forecast numbers in the article were exact to the same levels of precision. All I can say is… good for them.

I am at a loss to know what happens at the end of a calendar quarter, and especially at year-end, that compels normally smart and professional investment strategists to behave this way. Surely there is nothing about turning the page on a calendar that has an impact on earnings, margins, employment rates, currencies, and so forth? If there is uncertainty about the future of financial markets, why should it clear up so suddenly for so many analysts at year end, just in time to make their annual forecasts for the next year? I’ve personally never experienced this phenomenon where the month of December suddenly allows for forecasting market performance down to the decimal level, but I want to be clear that I am open to the experience. For the next few weeks I will be making a conscious effort to allow lightening, in the form of scientifically precise knowledge of future events, to strike. If it does, I promise the readers of this blog that you will be the second to know. My associates on the Pinnacle investment team will of course be the first.

Unfortunately, I’m guessing that our forecast for 2011 will evolve during the year, as has our forecasts for all of the previous years we’ve been actively managing portfolios. The main drivers of portfolio performance will be the strength of the US economic recovery, the problems in Europe, and the policy response to outsized growth in China. How these themes will play out during the year is difficult to forecast at the moment. During those times when the forecast is cloudy and the crystal ball isn’t overly clear, we tend to stick to widely diversified portfolios that are invested in a variety of different investment themes. BORING! I guess that’s why I’m unlikely to get a phone call any time soon from USA Today asking for Pinnacle’s 2011 forecast. They wouldn’t appreciate my answer that I’m 47.6% uncertain about the next twelve months of financial market behavior.

Forward-Looking

I have a quiz question for you. If you are an investor using the trend-following technique, you believe the trend is your friend. One of many methods used to identify a trend is to add up the past twenty, fifty, and two hundred days of prices, and then average them out in order to see if the moving average of price is trending either up or down. You then use this information to make a forecast about the future direction of the market, which you expect to continue in the direction of the trend. On the other hand, what if you use the mean reversion technique? Practitioners using mean reversion add up enough past price data to establish the average, or mean, price and then watch to see if the market is drastically diverting from the norm. If the price gets to two or three standard deviations from the average, you could be either a buyer or seller depending on whether current prices are above or below the average. If you practice mean reversion, the trend is definitely not your friend since you are betting that the trend will reverse to the mean or average of the past. Once again, mean reverters use past data to formulate a forecast of future market direction. So…which of these strategies is more “forward looking?” I’m guessing the answer is mean reversion, if only because the strategy requires the investor to execute transactions in anticipation of a market reversal, instead of waiting for the actual market reversal required by trend followers. Both strategies have obvious risks. For trend followers the risk is that the trend reverses and you are whipsawed in or out of the market in a trendless market. For mean reverters the risk is that the trend continues long past the point that standard deviation says it should. Or, there is a structural change in the market that changes the mean going forward.

How about traditional value investing? Traditional estimates of market value depend on forecasts of future cash flows, dividends, and earnings and discounting them at current interest rates to determine a “fair value” for a market or a security. I suppose you can’t get more forward looking than that. On the other hand, Pinnacle also studies measures of market value based on the average of five and ten years of past earnings. This method still requires investors to execute transactions in advance of a market move, but the data used to make the forecast certainly isn’t forward looking. Another important aspect of Pinnacle’s investment process is to analyze the global economic environment. One part of that decision making process is to analyze the Conference Board’s leading economic indicator, as well as the ECRI (Economic Cycle Research Institute) leading indicators, the OECD leading indicators, and a variety of market leading indicators including copper, commodity, and shipping prices. However we also look at numerous coincident indicators and all of the above are often compared to the data points of the past.

All of which is to say that Pinnacle is often forward looking in our investment process…which has its own set of risks and rewards. We recognize these risks by making small changes to our portfolios as the data is evaluated in real time. The natural result of the process is to avoid large asset allocation bets because we are often working in advance of actual changes in market trends. Investors are well-served because we have no philosophical problem marrying trend-following and mean-reversion in our decision-making process. Perhaps our biggest problem is trying to explain all of this in a simple way to Pinnacle prospects.

A Charlie Brown Forecast

Our investment committee met yesterday at the dreaded time of 1PM which means that everyone is trying to stay awake after lunch. The investment team did their usual stellar job of putting together an interesting and thorough presentation for the committee, and I’m happy to say that everyone seemed to stay awake. Towards the end of the presentation, my long-time partner, Dwight Mikulis, commented that we were making a “Charlie Brown investment forecast.” I suppose he could have meant that the after-lunch timing of the meeting reduced his understanding of the material to “Wa wa wa. Wa wa wa wa wa wa.” Or, he could have meant that our current market forecast is so wimpy that it reminded him of Lucy taking the football away from Charlie Brown right when he was about to kick it.

I’m actually sympathetic to either view of the Charlie Brown analogy. In fact, Pinnacle remains somewhat skeptical of the fundamentals underlying the current market rally. It is somewhat disturbing to see the list of problems that have not been resolved, including the high rate of unemployment, the structural problems with the length of unemployment and the number of potential employees who have given up looking for jobs, the record high amount of unemployed on government benefits, the number of problem Alt-A and Option ARM mortgages that are still sitting on bank balance sheets, the unwillingness of banks to lend and the subsequent fall in the velocity of money in the economy, the possibility of sovereign debt defaults in the EU, China’s potential property bubble and the potential for a sickening bubble-busting event, the continued fall of new housing prices, etc. Not to mention the structural problems of too much debt, higher taxes, higher regulations, and on and on and on.

These concerns are countered by the fact that the economy is now clearly expanding with GDP growth numbers confirming that the recession (in the consensus opinion) ended last summer. Inventories are being restocked, new unemployment claims are falling, and profits are surprising to the upside for the fourth quarter in a row accompanied by increasing revenues. The market remains amazingly resilient as even last week’s news of the SEC suit against Goldman Sachs failed to significantly derail the bull market. There is plenty of pessimism around to support the wall of worry needed for all bull markets. So our forecast is for the market to drift higher with the caveat that there are lots of reasons to worry. So call it a Charlie Brown forecast if you must. I still don’t think it is appropriate to be wildly bullish or bearish in the current market environment.

Tony Boekh on Sound Money Management

The Gloom, Boom, and Doom Report is one of our favorite pieces of institutional research. Written by Marc Faber, it is one of the most stimulating and contrarian reads you are likely to find. I highly recommend it. In the March letter, Faber quotes from Tony Boekh’s upcoming book, The Great Reflation. Boekh is a former lead editor for BCA Research, another of our favorite institutional reads. Sometimes you read something that is so good that you just have to share. Here is Boekh discussing portfolio management:

From my 40 years in the business of trying to understand and predict markets, I cannot emphasize strongly enough the importance of having a mental framework of how markets work and how to integrate into this framework different indicators, which reflect the various forces that drive markets. Without that, the investor is like a boat on the ocean without a rudder, with the direction determined by which way the wind is blowing. In the world of investments, Wall Street blows by far the most wind, and it does not have the investor’s well-being in mind, only profits and bonuses for employees and shareholders of the firms there.

A framework of analysis for understanding markets is not the same as building a model or set of indicators fitted to back data. I can assure you, from a lot of experience that they always break down. An eclectic approach that is based on common sense, strong logic, and objective data, balanced by right-brain intuition and lots of curiosity, is what works best. The investment world will never be deterministic, never amenable to scientific models, at least for any period of time. Some approaches work well in some periods, other approaches in other periods. Successful investors not only know how to think outside the box but, from experience know what to pay attention to in each market environment.

What a beautiful statement of an investment philosophy that perfectly matches our own. As active portfolio managers, we are always trying “to think outside of the box” and to “use our experience to know what to pay attention to in each market environment.” Thank you, Tony, for saying it so eloquently. Needless to say, I will be buying his book ASAP.

“This or That is Going to Happen”

I have often written about the industry’s insistence on denying that professional investing has anything to do with making forecasts. Making forecasts is all about making market “predictions” and market predictions seem to be no different than selling snake oil to the suckers who will do anything to believe in a cure. Here is what one of our favorite fund managers, John Hussman, has to say about forecasts in his Weekly Market Comment (Clarity and Valuation, Dec 21, 2009):

Probabilities, however, are not certainties. If the probability of a given event is “p”, then the probability of “not that event” is (1-p). This, in my view, is what makes probabilities and average outcomes different from forecasts. When people forecast, they say, “this or that is going to happen,” and very often they establish investment positions that will do them a great deal of harm if they are incorrect…”

There is no doubt that an investor who makes asset allocation decisions based on a forecast that says, “this or that is going to happen,” is taking on a very large risk that his or her forecast could be incorrect. At Pinnacle, our asset allocation is based on our best assessment of the economic and market data as we see it in “real time.” We are all about assessing the risks to our forecasts, if that’s what they are. We want to better understand our level of conviction in our forecasts, because if we have a low conviction forecast we are going to allocate assets closer to our pre-agreed benchmarks for risk that we’ve established with our clients, and we are going to be more diversified in our approach to sectors, countries, industries, etc. As we get closer to being able to say, “this or that is going to happen,” our conviction is higher in our forecast and we can have large deviations from our benchmark and more concentrated positions in the portfolio.

So, Pinnacle makes a different kind of forecast. Instead of saying “this or that is going to happen,” we say, “We have a high or low conviction in the probability of this or that happening.” I guess I’ll stick to my guns and proudly say that our statement about the probabilities of future events occurring still constitutes a forecast, and I will let others deny that they make them at all. Either way, we strongly believe that our approach gets to the heart of the matter, which is that no one can know the future with certainty. Those who invest as though they do should beware.

Paul McCulley Strikes Again

Paul McCulley is the managing director of Pimco (Pacific Investment Management Co., one of the largest bond investors in the world) and each month he writes a piece called Global Central Bank Focus. This month, in an essay called, “Because I Said So...,” McCulley discusses the “old” rules for Central Bank policy for fighting inflation and relates the “new rules” for inflation fighting to parents who sometimes tell their children, “Because I said so.” I can’t do full justice to the piece on the blog so please read it for yourself at:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/McCulley+Sept+Because+I+Said+So.htm

For those of you who are not economic wonks, McCulley reminds us that for many decades our central bank has targeted inflation without regard to the prices of assets or the impact of potential future asset bubbles. The rule for inflation targeting is called The Taylor Rule after economist John Taylor. The rule suggests the elements for the inflation targeting equation are: 1) The neutral rate of inflation that would theoretically exist if inflation and employment were both at “target,” 2) The inflation rate itself, 3) The gap between actual inflation and target inflation, and 4) the gap between the actual unemployment rate and the theoretical “full” unemployment rate. McCulley points out that asset prices are nowhere to be found in this equation for targeting inflation, and that U.S. central bank policy has been to suggest that asset prices are implied by the other inputs to the Taylor Rule, so the Federal Reserve doesn’t need to forecast asset bubbles as they appear in the economy. The stated policy is to wait for the bubbles to burst and then use a “mop up” strategy when the bubbles actually do burst.

Well….its clear that something has to change in our approach to asset bubbles, and McCulley opines that in the future the Fed will have to take a countercyclical approach to policy that “leans against” boom bust cycles by changing capital/margin requirements for banks and by reforming the bankruptcy laws. But what really caught my eye were McCulley’s final thoughts about forecasting asset bubbles and creating new paths for central bank policy, since forecasting is a subject we spend a great deal of time studying here at Pinnacle. He says, “Yes, that will sometimes mean taking action that is not fully anticipated, based on old rules of the game. But just like parents, central banks (read money managers) must exercise judgment, and sometimes, good judgment does involve making decisions on the basis of where the gut says the brain is going.” Thanks, Paul. I couldn’t have said it better myself!