Investment Outlook - First Quarter 2016

The Year in Review and the Year Ahead

The Annual Forecasting Follies

A recent Wall Street Journal headline read "Forecasters Bruised by Tough 2015." According to the Journal, financial market prognosticators came up short on their predictions across the board. Oil prices fell further than they thought, consumers saved more and spent less than forecasted, and the Federal Reserve ("Fed") increased interest rates much later than experts expected. The head of the St. Louis Federal Reserve, James Bullard, commented that Federal Reserve economists, all 300 strong, completed a "hat trick" of forecast misses last year. They were off the mark with their projections on economic growth, inflation, and unemployment.

At this time last year, we led off the first quarter Investment Outlook with a section entitled "Fearlessly Predicting the Unpredictable." We referenced that at the end of 2012, Wall Street stock strategists forecasted a 6% gain for 2013. The U.S. stock market ultimately gained 14% in 2013. At the end of 2014, stock strategists predicted a gain of 8% for 2015. The actual result was plus 1%. Forecasts for bond yields were also off the mark. In both years, economists expected the 10-year Treasury bond to finish in the 3.4% - 3.5% range. The final yield in both years was less than 2.2%.

In light of the apparent difficulty by experts (present company included) in making more accurate economic and financial forecasts, we were intrigued by a new book entitled Superforecasting: The Art and Science of Prediction, by Philip E. Tetlock and Dan Gardner. The authors reach several conclusions based upon the results of a forecasting experiment that they have been running for years. As we referenced above, they start off by concluding that many well-quoted forecasters are often dead wrong. According to the authors:

  • Many of the most well-known forecasters (including television's talking heads) are actually lousy forecasters.
    • They receive unwarranted publicity for their willingness to appear on camera, great storytelling ability, and certainty of their convictions. The authors have actually found an inverse relationship between fame and accuracy -- the more famous, the less accurate. They consider these better-known forecasters to be entertainers not skilled predictors.
  • The authors are especially dubious of the ability to make longer-term forecasts. In the book there is a copy of a memo written by Linton Wells in 2001 called "Thoughts for the 2001 Quadrennial Defense Review." Evidently, Defense Secretary Donald Rumsfeld sent the memo to President Bush and Vice President Cheney to show how strategic geopolitical and economic issues change radically from decade to decade. This type of unforeseen dramatic change leads the authors to conclude that "expert" opinion declines to pure chance when a forecast is longer than five years.
  • Nonetheless, the authors are convinced that some people can be very prescient -- superforecasters -- even though they have no training or experience in the area that they are forecasting.

According to the authors, superforecasters are better predictors because they embrace a different mindset than others.

  • They are open-minded -- they avoid making up their minds quickly based on anecdotal observations.
    • They avoid absolute certainty around big ideas that can be told as tight, clear stories that grab and hold audiences.
    • They embrace many insights, not one insight, and digest various opinions.
  • They are careful, focused, curious thinkers.
  • They are introspective and examine their own mistakes.
  • They are also willing to reverse course and change their minds.

A Feasible "Big Picture" Outlook

If financial markets are so difficult to forecast then why do so many investment firms publish annual forecasts such as this? And, secondly, how much do these "big picture" forecasts affect portfolio decisions relative to more current, concrete issues? The time honored areas to analyze for forecasting the big picture are global economic growth, the level and trend of interest rates, and the valuation of stocks.

Economic Outlook. We think the U.S. economy is on a steady course to grow in the 2-3% range in 2016 and probably 2017 as well. There is not much debate about the U.S. growth trajectory, and financial markets view the growth as neither too hot nor too cold. It is an entirely different story outside our borders. Investors are very uncertain about international economies. China's growth rate is clearly decelerating, for example, but the issue is, to what extent? Europe's sluggish growth is challenged by new factors, particularly terrorism threats and the surge in refugees. If these less predictable important economic regions prove to be even weaker, then corporate earnings will be weaker, which will weigh on stock prices. We think the odds favor more near-term disappointments in international economies, offset somewhat by more stable growth at home. If that proves to be the case, we would judge the global economic backdrop as edging more toward negative than neutral for financial markets in 2016.

Interest Rates. At long last, our central bank finally raised rates in December, three to four years later than most experts predicted. Markets will be largely focused on our Fed as international central banks leave their rates alone. The Fed is projecting a very gradual increase in rates over the next two years. Financial futures markets are expecting interest rates to increase at an even slower pace. If financial markets are correct, and they have been more accurate than the Fed over the past few years, then slightly higher rates are unlikely to be a big negative for markets. However, it is hard to argue that gradual increases will be a positive since low rates persisted through 2015, and the market was flat.

Stock Valuations. With both earnings and stock prices making very little progress in 2015, the valuation of the broader market is relatively unchanged -- neutral to somewhat elevated by historical averages. However, unlike prior years, there have been some major declines in both earnings and respective valuations in major sectors. Stocks in the energy sector declined 25% in 2015 and metals and mining equities were off nearly 40%. Many of the hot growth stocks that came public in 2013 and zoomed to sky high valuations were also pummeled last year. All in all, we see valuations as a net neutral in the market with fewer and fewer signs of speculation.

Other Market Factors. We normally do not try to weigh geopolitical factors too heavily for two reasons. First, geopolitical events are highly unpredictable and, second, barring a major war these events usually take a back seat compared to the financial factors mentioned above. However, with the Presidential election in 2016 and the high level of tension emanating from the Middle East, markets may be more driven by these developments than normal. Global terrorism and developments out of the Middle East stand the greatest chance of causing market turmoil throughout the year. Events in this region will also be of great importance to oil prices. If there is a single weak link in the global financial structure at this time, our vote would be for problems spreading from lower and lower oil prices. Stabilization in commodity prices would be a big relief. A continued decline in commodities will spell more trouble for markets. The bottom line is that rising geopolitical tensions are likely to be a greater problem for financial markets in 2016 than they have been in recent years.

Wrestling with the Here and Now

Although thinking about big picture "macro" issues is important, most investors spend considerably more time analyzing company and industry trends, particularly those that affect their current holdings. There is no shortage of current issues to evaluate at the industry and company level:

  • Will companies continue to be aggressive buyers of their own stock to boost earnings?
  • Will the drug industry still be able to price new specialty drugs at record levels?
  • Will merger and acquisition activity continue at the 2015 pace, or will the Justice Department block several, large announced deals?
  • Will the decline in traditional television viewership slow, or will services like Netflix's continue to gain eyeballs?
  • Can brick and mortar retailers, such as the largest, Wal-Mart, mount an offense against virtual retailers, such as Amazon?
  • Will bank profitability improve enough with higher rates to offset their exit from other more profitable business lines?

Investors once again will be tasked in the New Year with evaluating continued changes in industries and companies in order to separate winning business models from compromised ones. Investors benefitted in 2015 by the strong market performance of solid business models with the likes of Google (now Alphabet), Facebook, Visa, Disney, Starbucks, Nike, Amazon, and others. Will those companies maintain their strong performance going forward, or will their respective increases in value reduce the odds of outperformance in 2016?

The purpose of our Investment Outlook is to discuss some of the issues that our investment group is thinking about. Unfortunately, any outlook always has more questions than definitive answers. Most investors take a crack at predicting future events, but more importantly, they need to react objectively to unexpected developments. Some of the questions and uncertainties we have raised in this Outlook will be resolved during the next twelve months and many more left undecided. In the meantime, the current consensus forecast for 2016 by Wall Street strategists is in. They expect a gain of 8% this year, just as they predicted last year.

After posting a 1.4% gain in 2015, we wondered how often the stock market put together back-to-back years of single digit gains as most strategists are predicting for 2016. In the last 90 years, the stock market has advanced by single digit returns in consecutive years a total of ONCE. That occurred in 1947 and 1948. Based on historical patterns, markets are more volatile on an annual basis than many appreciate. If the uncertainties break to the positive side, double-digit gains would not be surprising, especially after such a difficult 2015. If the down cards turn up weak, however, stock market turbulence seems more probable.

Happy New Year!

Bob Milnamow
President and
Chief Investment Officer
January 2016

Important Disclosures:

  1. This presentation may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as "believe," "estimate," "anticipate," "may," "will," "should," and "expect"). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.
  2. Historical performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.
  3. Investment in securities involves the risk of loss of interest and/or initial investment capital.
  4. Nothing in this presentation is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.
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