Why you should ignore industry experts’ forecasts

If history is any guide, most index forecasts, stock price targets and views on commodity forecasts will miss the mark by a wide margin. Predictions for the year ahead are not analysts’ strong point.

Fund Managers should realise that its annual gamble might look like fun, but does not impress clients. At a time when the City needs to win friends and demonstrate it is doing an important job for the economy, forecasting brings big risks. It simply looks unprofessional.

Usually, the optimism of a Christmas rally dominates sentiment about the coming year, but this time things look different. The record suggests that there is little room for nasty surprises in the Pollyanna world of market predictions. The City is not good at factoring in turmoil or politics; issues like trade wars and a changing political landscape are left out.

Recent months have shown little sign that strategists are getting ahead of the crowd. In August 2011, when the S&P was down 11 per cent, a poll of strategists showed that they were as confident as ever about their year end targets. The average forecast was 17 per cent higher.

Even as the forecasting year progresses, and targets seem even more unlikely, it seems a year end rally is always factored in. When our deepest convictions are challenged by contrary evidence, surprisingly what usually happens is that our beliefs get stronger. The mere act of polling strategists seems to make them dig in. Some even say they don’t want to be seen to react to a market move. It sounds robust to stick with something, even in the face of new evidence.

Company research often suffers from over-optimism. Recent S&P research showed that of the 1485 stocks that make up the S&P1500, none had a consensus “sell” rating. Almost three-quarters were “buy” or “buy/hold”. Analysts typically have unrealistic expectations of corporate earnings growth, and this means overall consensus earnings shoot way ahead of reality.

One study, covering the last quarter century of US forecasting, shows that each year corporate earnings growth estimates have typically ranged from 10-12 per cent, but the actual outcome was just 6 per cent. Only twice during the earnings recovery following a recession have forecasts under-estimated actual earnings growth. The coming year does not look like one of those rare periods.

Behavioural finance highlights how much forecasting tends to be anchored in the present. Most economic forecasts move little from the status quo; today’s commodity prices and exchange rates are given far greater importance than they merit.

The way in which some polls are conducted - with single point forecasts and little context - is not helpful. If the exercise simply filled column inches as seasonal frivolity, it might not matter. But, some of this does find its way into client reports. It becomes part of the impression that clients and the public have of the City. They quickly come to realise that investment professionals are not good at making general predictions about the future.

There can be a danger, too, in strategists giving too much explanation. Familiarity lets us down; we are suckers for a plausible story.

This year, forecasts seem even more likely to be clustered together. Risk has been taken out of most portfolios with benchmark hugging, and we should expect strategists to be similarly cautious and consensual.

Investment professionals are trained in company analysis, modelling and wealth planning, and should stick to what they are good at. The City needs to recognise the damage forecasting is doing to its reputation.