2018 Predictions (Sort Of)

Saturday, December 16, 2017

By: Christopher P. Cline, CEO

It’s time once again for eggnog, office parties, family gatherings, hotly-contested college football playoffs and financial predictions from investment advisors.  Not wanting to follow the crowd, Riverview Trust Company wants to share its own insights for 2018. We can state, for certain, that the following will happen within the coming year:

• Equities - Stock prices will go up and go down.  But not necessarily in that order.
• Fixed Income - Bond prices will go up and go down.  But not necessarily in that order.
• Interest Rates - The Fed will raise rates at least once.  Unless the economy changes enough that it doesn’t.
• Bitcoin - Prices will fluctuate wildly.  And investing in it will still be no better than gambling.
• US. Economy - Economic productivity will remain strong for a while.  Then it will weaken.  Either this year or later.
• Politics - Partisan squabbling will continue indefinitely.

OK, that was kind of fun.  But it also stands for a more basic truth:  Any prediction that attempts to be more specific is simply a guess.  And in investing, educated guesses are no better than uneducated ones.

In his Wall Street Journal article of November 24 entitled, “Those 2017 Predictions: So Wrong,” James Mackintosh identified two lessons to be learned from the mistakes made by analysts in their crystal-ball gazing.  The first is that “when everyone agrees that prices can go only in one direction, it is dangerous.”  The second, more important, lesson is that “we really know an awful lot less about how the economy works than we thought.”

Mr. Mackintosh observed that late last year, “almost everyone was bullish about the prospects for the ‘reflation trade’ of higher bond yields, stock prices and the dollar, driven by rising wages and Donald Trump’s tax-cut plans.”  However, as of the date of the article, benchmark Treasury yields and the dollar were down, inflation was nonexistent, and stock prices had hit highs no analyst had predicted.

Noting that “[p]redictions have a dire track record, and have been sadly predictable themselves,” Mr. Mackintosh nevertheless doesn’t blame Wall Street for the miserable performance.  Instead, he notes that markets already incorporate an “average” prediction, so “forecasting markets involves assessing when the average prediction will change.”  In other words, markets are largely efficient (meaning that all information is widely known about the markets and is already built into the price), so a prediction about market direction must contain information that the analyst making the prediction knows but that few others do.  This is an obvious contradiction.

On its face, the annual game of making predictions seems harmless enough.  However, it can have real world consequences.  Take “tactical allocations,” for example.  This is the process by which investment advisors over- or underweight certain sectors based upon their guesses about the global economy.  These aren’t big bets, but rather “tweaks” to a portfolio that is primarily designed on an asset allocation model. 

So, for instance, an advisor may start with a portfolio model that calls for 10% international developed market stocks and 5% stock in emerging market stocks (that is, investments in companies located in countries with less-developed economies).  This advisor may feel that, because of its heavy debt load, China’s economy will slow in the coming year, and that the emerging markets that depend on sales to China also will slow. 

Based on this assumption, the advisor may vary from the basic model by investing 12% in developed market stocks and only 3% in emerging markets.

This approach sounds reasonable.  It may even give the advisor’s clients some comfort that the advisor is closely watching the portfolio, applying investment skills to take advantage of current conditions.

Unfortunately, however, there’s no evidence that it works.  In fact, it plays to the advisor’s advantage regardless of outcome: if the tactical choices turn out well, the advisor can brag about her acumen; if they turn out poorly, the advisor can always say, “well, the change only affected a small part of the portfolio.” 

Common sense (usually not a helpful tool in investing decisions) confirms that tactical allocations are a bad idea.  If you’re sure that the tactical choices are right, then why aren’t you all in?  And if you aren’t, why are you doing it at all?

The truth is, any predictions beyond those described above are worthless.  In the world of investing, any data that isn’t reflective of long-term, persistent trends is just noise.  The only factors that matter in determining investment choices take years to unfold.

So limit your predictions and gambling to the college football championship.  When it comes to your investing, though, stick to the dull, steady (and sometimes nerve-wracking) work of creating an evidence based plan and sticking to it.