Andrew Hallam
Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.
Financial analysts and investment publications put on wizards' robes at the start of every year. They guess where stocks will go. They guess future bond yields. They take divine stabs at the Canadian dollar and the future price of oil. But like the man behind the curtain in the classic Wizard of Oz, they pump plenty of smoke into a room filled with mirrors.
Steve Forbes, the editor-in-chief of Forbes magazine sums it up best. "You make more money selling advice than following it. It's one of the things we count on in the magazine business – along with the short memory of our readers."
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Let's draw the curtains back. Bank of Montreal, Canadian Imperial Bank of Commerce, National Bank Financial, Royal Bank of Canada, Bank of Nova Scotia and Toronto-Dominion Bank all weighed in with their predictions for 2016. BMO was closest when predicting the year-end level of the S&P/TSX composite. The bank predicted 15,300 points. On Dec. 30, it stood at 15,287 points.
They also tried to guess the year-end price of oil. But BMO was off by a jaw-dropping 19.4 per cent.
Who got the government of Canada 10-year bond yield right? CIBC was closest. The bank guessed it would be 1.74 per cent. It was 1.72 per cent. But CIBC was the worst of the banks to predict the level of the S&P/TSX composite. By the end of 2016, the bank was off by a whopping 11.2 per cent.
National Bank Financial's predictions weren't too far off the mark with Canadian stocks and bonds. But they had the worst prediction for the year-end price of oil. NBF was off by a massive 25.6 per cent.
So which bank forecasts should you follow this year? None. Financial predictions are dice rolls. Longer-term predictions can be closer to the mark. But I'll get to that in a moment. If you're tempted to listen to short-term forecasts remember what Warren Buffett says. "We [he and Berkshire Hathaway's co-chairman, Charlie Munger] have long felt that the only value of stock forecasters is to make fortune-tellers look good." Evidence backs that up.
Vanguard published a report that looked at popular metrics used to predict stock-market returns. Researchers Joseph Davis, Roger Aliaga-Diaz and Charles J. Thomas looked at data from 1926 until 2012. They examined price-to-earnings ratios; cyclically adjusted price-to-earnings (CAPE) ratios; trailing dividend yields; corporate earnings growth trends; and a consensus of predicted earnings growth. That was just a start. They then looked at five different measurements of economic fundamentals, followed by three different multivariable valuation models.
In the end, they concluded what Mr. Buffett says. The researchers reported, "Stock returns are essentially unpredictable at short horizons … this lack of predictability is not surprising given the poor track record of market-timing and related tactical asset allocation strategies."
Financial analysts have their noses in economic data. But that isn't enough to predict future market prices. Short-term price movements (whether it be stocks, bonds, oil or gold) are influenced more by human emotions than they are by economics.
Norbert Keimling, head of Star Capital Research, says: "There is virtually no correlation between the market forecasts for the next year regularly published at year-end and the actual performance in that year."
But Mr. Keimling does say that longer-term forecasts deserve some respect. He references the CAPE ratio. Yale University professor Robert Shiller designed the CAPE ratio to compare stock prices with 10 years of real earnings. It's like a P/E ratio, but it's a tougher yardstick. It discounts dramatic single-year earnings swings. Prof. Shiller found that when stocks trade well above their historical average CAPE levels, they drag their heels in the decade ahead. When CAPE levels are below average levels, stocks often do well in the decade ahead. Mr. Keimling says it's much the same for international markets.
According to researchers at Star Capital the historical average CAPE level for U.S. stocks is about 16 times earnings. The firm posts CAPE levels at the end of every quarter. For the quarter ended Sept. 30, U.S. stocks traded at 25.5 times earnings. This doesn't mean they won't have a good year or two ahead. They might. But it doesn't bode well for the decade to come.
Canadian stocks look better. The historical CAPE level is about 19.3 times earnings. This time last year, I wrote that Canada's CAPE level stood at 17.4 times earnings. Based on Prof. Shiller's research, I wrote that Canadian stocks should have a good decade ahead. By Sept. 30, 2016 (the most recent quarter from which CAPE data was available), Canadian stocks were fairly valued, posting a CAPE level of 19 times earnings. That's after a nearly 16-per-cent gain for the S&P/TSX composite index to Sept. 30.
Developed-world international stocks have been testing investors' patience. During the past one- and three-year periods, they lagged U.S. and Canadian stocks. But their time will come. The historical average CAPE level for developed world international stocks is about 20 times earnings. It was about 15 times earnings on Sept. 30. That doesn't mean your international stock market index will have a good year ahead. It could, once again, be the bum in your portfolio. But the longer term future looks good.
Nobody can predict short-term stock-market movements. When experts bring out magic wands, stuff wax in your ears. Build a diversified portfolio of low-cost index funds. Add money every month. Rebalance once a year. Over an investment lifetime, your money should do well. That's based on evidence, not a smoke-and-mirror show.