‘Tis the season for… stock market predictions!
Back when I was a wee credit analyst, my boss would ask me if I got updated financial projections from the management teams of the companies in my portfolio and what I thought of them. When I was just starting out, I would struggle to answer that question because I didn’t think I should be completely honest with him. An honest answer would go something like “Yeah, I got them. I incorporated them into an exhibit at the back of this memo and then promptly threw them in the trash because, if the management team could accurately project more than three months out, I probably wouldn’t be sitting here asking you for a covenant waiver and a wholesale restructuring.”
As I got older and started running multi-bank syndications, I would have portfolio managers at other banks ask me what I thought of the annual projections that were provided. As one example, I worked with a large scrap dealer whose base business primarily involved copper. I finally started to answer the other portfolio managers’ questions honestly: “Management took the same volume they did last year, assumed recent metal prices remained the same for the next 12 months, and added two or three percent of additional volume for organic sales growth.”
“Is that realistic?” would always be the follow-up question.
“Beats me. If they could accurately forecast metals prices as well as supply and demand of the global scrap metal market for the next 12 months, they would have closed their processing and distribution business long ago and started a hedge fund. I would have invested with them and you and I wouldn’t be having this conversation today.”
For the scrap business, it was impossible to predict revenues for the year, but the management team was pretty good at forecasting volumes. Since, at its core, it was a processing and wholesaling operation, they used the volume data to figure out how many people they needed to process the scrap, how much storage space was needed, and how much capacity would be utilized on their machinery and equipment. As a portfolio manager I would then layer on a range of metals prices to see if they would have enough liquidity from their working capital to handle the inevitable price swings.
The scrap dealer’s projections weren’t worth much by themselves, but they gave you a lot of good insight into what the management team was thinking and planning.
While it has been shown time and again that pundits and other experts are generally terrible at making accurate predictions, stopping to analyze those predictions does serve a useful purpose. That purpose is not so much about determining whether management is right about the specific predictions, but rather a way to garner insight into thought processes, decision-making ability, and maybe even their motivations.
How to Make Stock Market Predictions Useful (vs Making Useful Predictions)
For some people, the job is to make useful stock market predictions. It’s both a marketing stunt and ultimately a way for them to make boatloads of money for themselves and their clients if they get it right. Take Jeff Gundlach’s list of annual predictions. Gundlach is the founder of DoubleLine Capital and runs the Total Return Bond Fund. Every year he makes a few broad predictions for global markets. For 2019, he predicted the following:
- The US dollar will be weaker, which will lead to outperformance among emerging markets.
- Stay out of Europe, which is a value trap.
- The US stock market will retreat or non-US markets will rally to catch up.
- If you don’t mind volatility, buy Bitcoin.
- Commodities have a 50+ percent chance of going lower.
- Get out of junk bonds because of excessive leverage across companies.
Very seldom does someone who manages a ton of money make public predictions that are so black and white and not covered with caveats and asterisks. This is why Gundlach is so much fun.
Let’s take a look at the YTD charts for each of these predictions and see how he did. But first, to be fair to Gundlach, remember that he only publicly made predictions on broad themes. He could have privately focused on individual components within those themes and could have had a different outcome than the charts below.
US Dollar – $UUP
Europe – $EFA
Bitcoin – $NYXBT
Commodities – $DBC
Junk Bonds – $JNK
As you can see from the charts above, Gundlach’s market predictions were way off when it came to dollar strength, Europe, the US stock market retreating, and junk bonds going lower. He was right on bitcoin and commodities. The thing is, his fundamental analysis on the other calls might not be wrong. He’s an incredibly smart guy with a lot of smart people working for him, and over the next 5 or 10 years he might be proven correct. However, the way you make the best risk-adjusted returns is to not only get the fundamental backdrop correct but also the timing.
While a lot of people think trying to time the markets is a fool’s game, for those who want to attempt it themselves the key thing to remember is to only trade a fundamental thesis when the price momentum agrees with you. If you don’t respect price momentum then you would have been on the wrong side of two-thirds of Gundlach’s predictions. If you waited for price to go your way, even using something as simple as a long-term moving average, you would only have traded two themes in 2019, but both of them would have been winners (depending on how you traded commodities).
Predictions for Fun
The last point I’ll make about predictions involves two fun games to play. The first, I learned from the strategy and research group of a bank I used to work at. In addition to their normal annual predictions about the business and macro environment, the members of the group would compete against one other to see who could make the most outlandish, yet probable, prediction possible. The point of the exercise wasn’t to be right; after all, the odds of what they tried to predict were supposed to be low. Instead, the point of the exercise was to draw them out of their comfort zone, force them to think critically, and encourage them to look beyond the day-to-day research and data they normally worked with. It also allowed them to be more creative and open with their thought processes. I always thought it was a good exercise and a more useful one than trying to guess the macro future.
The second game is one I’ve played with a group of my college friends since we graduated. Every year on New Year’s, whether we’re together or not, we each write down predictions for the next year. They typically involve family, careers, and occasionally politics. We also periodically write down predictions for 5 years out. One person saves all the predictions (without looking at them) and then each subsequent New Year’s they are opened, read aloud to the group, and we all have a good laugh as to how uncertain even our own futures often turn out to be.