Ask a random stock market ‘guru’ at the beginning of the year what he or she expects what equities will do that year and you will probably get an answer like this: ‘Well,… somewhere between the 5 and 10%.’ And this year is no exception. The average Wall Street forecast for the return on US equities is +7.5%. More importantly, this average includes very little outliers (see for example here and here). Plus or minus 20%, or even more extreme, is (almost) never the answer. And while that may sound logical, it is, in fact, not!
Sticking with the average
Please take a look at the graph below. It shows the calendar year returns on the Dow Jones Industrial Average Index since 1900, ranked from lowest (left) to highest (right). During this period, the return on the Dow Jones has averaged 7.4%. From this perspective, a return forecast of 5 to 10% doesn’t sound that crazy. You take some safety margin around the long-term average and you’re probably good, right?
Click to enlarge
Wrong! A forecast like the one above is naive. If we zoom in on the graph, we see that, since 1900, the return on the Dow Jones has been between 5 and 10 percent in just ten occasions (the black bars). That’s not that often given the time span of 118 years.The Dow Jones return falls comes in between 5 and 10% zone roughly 8% of the time, or just in one out of every 12 years! Conclusion: ‘Gurus’ forecasting a return of between 5 and 10% would have got it wrong most of the time.
Eternal optimists and permabears
Instead, you would have been much more successful by predicting a return of 20% or more for every single calendar year. In no less than 31 out of the 118 years since 1900, the Dow Jones generated a 20%+ return. As a reminder, 2017 was yet another year where the Dow went up more than 20%. This, ‘obviously’ too optimistic view on the stock market, has a success rate of 26%(!), three times bigger than the success rate of the conservative 5 to 10% return forecast.
And what about the permabears? They too had ‘outpredicted’ the ‘stick with the average’ forecasters. Pessimists, who dared to predict a negative return of 20% or less for every single calendar year, got it right in eleven out of 118 years since 1900. Still one more than forecasters predicting a return between 5 to 10%.
If anything, the statistics above show that the number of ‘doomsayers’ and ‘eternal optimists’ in the market is probably too low, instead of too high. Too few forecasters take the historical return distribution into account and bet on massive equity rallies or heavy losses. Perhaps there is some logic behind it. Because who has the ability to forecast the Dow Jones for 118 years? But more importantly, predicting a stock market bubble in a year when stock prices collapse is probably a bit too damaging for your guru status.