Index forecasts are not a suitable basis for investment decisions

2022 was not a good year for shareholders. After starting the year at almost 16,000 points, the German share index (DAX) now stands at 14,400 points (as of 28 November) – a decline of 10 percent – having even dipped briefly below 12,000 at one point during the year.

The reasons for this weak year in the stock markets are easy enough to list: war in Ukraine, rising inflation and interest rates, and fears of recession. We are living through an age of multiple crises on a scale few of us have ever experienced before. While we, as players in the financial markets, are perhaps reasonably familiar with crisis situations such as the dotcom bubble, Lehman and the debt crisis, the simple fact of the matter is that we in the general population are now learning what crisis really means – and what it feels like to face major economic uncertainty.

At times like this, it is natural for us to be particularly receptive to forecasts, especially those relating to the volatile capital markets. And so there will be another big flurry of activity in the run-up to Christmas this year, not just for retailers but also in the research departments of financial institutions as they prepare their predictions for the next 12 months. These forecasts will, in turn, be given plenty of space and attention by the financial editors at newspapers and magazines.

“It’s tough to make predictions, especially about the future...”

It is astonishing to see how much interest these index forecasts attract every year, even though most investors will appreciate that point predictions seldom prove to be accurate. Nevertheless, these “shots in the dark” should not be dismissed entirely, as they are usually the result of comprehensive macroeconomic modelling that takes into account a multitude of different factors, all prepared by experienced analysts who spend all day exclusively analysing the individual metrics that go into these forecasts.

These calculations are based on everything from Nobel Prize winner Robert Shiller’s research on the causes of temporary mispricing of equities and equity markets all the way to the frequently-used calculation of the so-called average stock market year, which is based on the statistical concept of expected value. In this case, the predicted index level is the average expected value, although this in itself often does not prove accurate, as the equity markets regularly overshoot in one direction or the other.

There is no such thing as a reliable forecast.

And that brings us to the subject of human psychology, which is ultimately responsible for this market mispricing and is in itself difficult to predict. This is particularly true in times of crisis such as the ones we are living through right now, in which there are so many exceptional events that you would need a crystal ball to get anything even reasonably correct. Nobody was anticipating Russia’s attack on Ukraine on 24 February – even as recently as the end of the previous year. This highlights another problem with index forecasts, namely the discrepancy between the time at which the prediction is made and the forecasting horizon, which is usually more than 12 months.

That investors crave these forecasts despite their obvious shortcomings can be explained by our tendency to reach desperately for anything that might offer assurance, clarity and control in times of great uncertainty. And that is precisely what forecasts do: they give investors a feeling of security, ease their decision-making and even give them excuses as, if their decisions later turn out to be wrong, they can at least say they made them based on expert knowledge.

Yet forecasts still have a part to play.

So how should investors respond to index forecasts? By ridiculing them, or perhaps by ignoring them?

No. The best way to deal with these estimates is to critically assess them, make good use of what you learn from them, and take the trouble to understand why a forecaster is convinced that the DAX, for example, could rise over the course of the next year. After all, what really matters when it comes to index forecasts is not the specific price target but the considerations and arguments underlying it. If you look at different estimates and the justifications for them, you end up with an array of scenarios that you can weigh up, categorise and use to form your own opinion.

As active stockpickers, index forecasts simply provide us with a rough guideline. We look at various estimates for the coming year and use them to derive an overarching trend for the equity markets. Apart from that, we do not allow ourselves to be heavily influenced by the general economic and political climate, instead opting to consistently monitor the individual companies in our universe as part of a bottom-up approach. In doing so, we only invest in small and mid-cap companies, remaining in close contact and constant dialogue with their management as we do so. As we have often been investing in these companies for many years, this enables us to assess as effectively as possible which companies will emerge stronger from a crisis and which will not.

Even this crisis will have its winners – no matter where the index ends up in 12 months’ time.

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Source:
Robert J. Shiller, Irrational Exuberance, 3. erweiterte Auflage, Princeton University Press, 2016
Hanno Beck, Was Prognosen bei der Geldanlage taugen, Frankfurter Allgemeine Sonntagszeitung, 22.10.2017
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