I recently wrote a couple of articles about stock market forecasts and why they’re so often a waste of time. The first was an article about an alternative approach to stock market forecasts. It included a chart showing the range of values the FTSE 100 could have reasonably taken in the last 25 years, compared to the values we actually got.
But forecasts are all about the future, so in another article I outlined my stock market forecast for the next seven years, and that’s what I want to dig into a bit more here.
A range of probable outcomes
It’s important to start off by saying that any forecast, or prediction, which gives a single number, such as 6,500 by the end of the 2013, is ridiculous.
It’s far better to say that the stock market might reasonably end the year between 5,000 and 7,000, but investors generally don’t want to hear that; they want precision, even if the statement is precisely wrong.
It may feel uncomfortable to look at a forecast which gives a wide range of possible values rather than a specific value, or a narrow range. However, that is the price of enlightenment. You can believe that a precise forecast is accurate (which it won’t be, other than by luck), or you can admit that the future really is very uncertain, and prepare to deal with reality as it actually is, rather than how you would like it to be.
As Richard Feynman said:
“The first principle is that you must not fool yourself, and you are the easiest person to fool.”
The chart above uses the same approach as the one I used before to show how the market has historically moved within a range of reasonably possible values (reasonable by historic standards).
The range is based on the market’s CAPE (cyclically adjusted PE) and a few assumptions:
- Cyclically adjusted earnings (10 year, inflation adjusted average) head upwards at 4% a year, which is about the historical average.
- The maximum growth or fall in the market in a year is 20%.
- The FTSE 100 will continue to have a CAPE valuation in line with historical trends, where the average figure is 16, and the upper and lower extremes are 8 and 30 respectively.
The upper leading edge is my “maximum optimism” forecast, and would occur if everything went right and investors became as absurdly optimistic about the stock market as they were about stocks in the 90s and houses in the 2000s.
The lower edge is my “maximum pessimism” forecast, where everything goes wrong and we have the “death of equities” all over again.
More bullish than bearish
This model forecasts much more upside than downside, which I think is reasonable, but is certainly not a mainstream view (although that’s no surprise – when the mainstream view is bullish, future returns are more likely to be poor).
The dark green band is the most “likely” outcome, according to this model, but the two medium green bands with CAPE ranging from 12 to 22 are also quite normal and so you shouldn’t be surprised if the FTSE stays anywhere within that range.
In terms of forecasts, the central forecast (dark green) for the end of 2013 is for the FTSE 100 to be somewhere between 6,900 and 7,500. That seems a bit optimistic, but who am I to argue? It wasn’t long ago that the index was at 5,000 and yet now it’s around 6,300.
The extreme forecast for the end of this year (which includes all reasonably likely values) is that the index will be somewhere between 5,000 to 7,500.
Generally I think one year forecasts are a bit pointless, but longer-term I agree with this model – there is much more upside than downside, and the long sideways market we’ve had this past 15 years may soon be coming to an end.
However, having said that, I will continue to sit on the fence and say that in the worst case scenario we could still be at 5,000 in 2020. Although the good news is that in that case the FTSE 100 would probably have a dividend yield of five or six percent, and the odds of a colossal bull market would be increasing all the time.
Is this forecast so vague as to be useless?
For me this forecast, even though it does give a wide range of possible values, is an indispensable tool for understanding where the market is today in relation to the sort of levels that we can reasonably expect. Without this type of forecast investors are left with little to go on, other than the ‘support’ and ‘resistance’ levels so beloved of technical chartists.
If I had used it in 2000, then it would have told me that the most likely course for the market was down, with negative returns for many years… and that’s precisely what we got. Or that in 2009 the market was very likely to produce outstanding returns, which again is precisely what we got.
At extreme valuations this forecasting technique, and CAPE valuations in general, are incredibly powerful. The rest of the time, when valuations are relatively normal like they are at the moment, it serves as a reminder that the market could easily be up or down 1,000 points by the end of the year, and that I should be mentally prepared for both.