Mind The Gap: Wall Street Forecasts And YTD Returns

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Includes: DIA, QQQ, SPY
by: CFA Institute Contributors

By Salil Mehta, CFA

To put it mildly, some investors have suffered unexpected losses due to the continued market volatility at the start of 2016. This is in spite of the fact that, according to leading Wall Street pundits, the markets were supposed to rise by 8% this year. The chorus said that interest rates were going up, so stocks were the place to be.

None of it was true. And if you weren't in bonds, it cost you dearly. Over the three-month period ending in February 2016, the 10-year yield fell 30 basis points (bps). That's after rates were hiked in a move you could have seen coming from the International Space Station.

What Now?

Let's take a look at what we can see so far. Despite Wall Street's expected 8% rise, the S&P 500 fell 7% in December and January, while now bouncing back to even for the year. Five points of that decline came in January alone. But January's slide was only just greater than one standard deviation move. As we'll see though, that one month can still handily destroy expectations going forward.

The gap between the 2016 forecasts and the YTD returns through January is 13% (8% target minus the -5% YTD). Annual returns have a nearly 20% standard deviation (or 19% if you only look from the end of January onward). So it is still plausible - though rather unlikely, with only a one in five probability - to reach the 8% target gain for 2016. (For statistics wonks, the test statistic decomposes the 13% gap to a ~9% move in addition to the typical 4.5% annualized return, and then factors in a 19% standard deviation.) Now that we are further into the year (mid-March), euphoria and complacency are back to extreme market top levels.

It's also worth noting that strategists at major firms are consistently bullish, year after year. The sources of the most optimistic prognostications also don't change. Sorted from most to least bullish, they are Federated Investors (NYSE:FII), JPMorgan (NYSE:JPM), Prudential (NYSE:PRU), Bank of America (NYSE:BAC), and Columbia.


S&P 500 Forecasts by Firm
The Most Bullish Firms


In the table below, two pieces of information averaged among the 10 firms listed above are presented:

  1. The difference between the target and the January YTD returns.
  2. The rest of the year returns.

Gap between Projected and YTD Returns


If these analyst forecasts were mostly in the right direction, you would expect a positive linear relationship between 1 and 2. Regrettably, there is a negative relationship instead. Never mind that the market continued its drop in February, even after the revised forecasts, and the rebound leaves the market still below many firm's 2016, 2015, and even 2014 targets!

In other words, the larger the gap in January between the YTD returns and the year-end target, the more unlikely the chance the market will recover to the target by the year's end.

Think about this: For 2016, the 13% gap noted earlier (after the standardization adjustment) is the largest gap among this data. That's not a good omen.

Bear in mind that this is different from the "January effect," which is a market-inefficiency myth concerning the rest of the year returns based on the early month returns. Rather we are talking about strategists' forecasts in relation to the market - not the market relative to itself.

There are important takeaways from this recent crash. The first lesson is that significant ground has been lost. Despite the fact that markets are quite noisy, in this case, it is hard to expect the year-end targets to hold. In fact, they are subject to great final-month risk as well. A more important lesson is that you should always be defensive in our risk posture, particularly after the unsustainably intense post-11 February rally. A defensive posture means putting your own and your client's money to work across a reasonable range of asset classes and with a long-term view, not being overly influenced by forecasts that have been proven worse at predicting the future than a coin flip.

I recently wrote about the risks and benefits of target date funds, which have seen stability recently from rising bond prices even in the face of some equity losses in December and January. Investors following the outlined approach would have been happier and more confident not only in recent months, but in the peak market fear climate of August 2015 (coincidentally midway between 1 January 2015 and today). August was when the volatility regime finally flipped for good, after being low for many years. Investors would have had a strong liquidity position to take advantage of the market stress. Instead, they wound up being stressed!

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.