Proceed With Caution In Developing Short-Term Forecasts

Includes: CSCO, D, DUK, ED, JNJ, MCD, PG, SO, SPY, T, WM, XLU
by: Eli Inkrot

When considering the relevance of past predictions, many people will default to the proverbial phrase, "the proof is in the pudding." The underscoring emphasis of this saying is that we cannot know the validity of forecasts until they have been tested. I am here to suggest that even once the last bit of the pudding has been licked clean from the bowl, we still might not have all of the necessary information. That is -- even when one of your forecasts happens to turn out to be correct -- I would advocate humility and an appreciation of the process. Allow me to walk through a personal example to better illustrate this point.

I'm not a soothsayer, fortune-teller or even much of a forecaster. In fact, I usually go about my investing decisions by simply looking for profitable long-term business opportunities rather than by guesstimating on what may or may not happen in the next couple of months or years. So it might surprise you to learn that I have previously made a time sensitive prediction. Almost 11 months ago -- January 4, 2012 to be exact -- I happened to make the bold suggestion that those interested in the remarkable 2011 run of utility stocks shouldn't "get caught chasing last year's trend." If you're interested in the detailed explanation of the prediction, feel free to read the article, but here's a reasonable summation of my rationale:

2011 Result Jan 4th, 2012 1-year Consensus Estimate
Dow Jones Utility Index (DJU) 15%
Utilities Select Sector SPDR (NYSEARCA:XLU) 18%
Southern Company (NYSE:SO) 25.50% -2.50%
Dominion Resources (NYSE:D) 31% -2%
Duke Energy (NYSE:DUK) 30% -3.50%
Consolidated Edison (NYSE:ED) 32% -8%

Now to be perfectly clear, utilities are often a great place to look for a reasonable current yield, inherent stability and overall safety. But essentially my idea back in January of 2012 was that the recent utility run-up, when considered against historic outcomes, likely wouldn't continue into 2012. So given that I didn't have much going on anyway, I thought that now would be a good time to check in on my rare short-term forecast. How did I do?

Jan 4th, 2012 Dividends Nov 23rd, 2012 Total Gain
DJU $455.73 $440.59 -3.32%
XLU $35.24 $0.72 $34.09 -1.21%
SO $45.06 $1.94 $42.03 -2.41%
D $52.50 $1.58 $50.12 -1.52%
DUK $64.74 $3.03 $60.45 -1.95%
ED $60.58 $2.42 $54.10 -6.70%

Now two things should be noted here: first, Duke Energy had a 1 for 3 split, which I accounted for but effectively ignored for presentation purposes and second, time value of money calculations would have to be considered. In addition, it should be known that I didn't do anything that spectacular by reiterating what the consensus estimates were telling you. I suppose that's the nature of playing the analysts' short-term game; but it remains that if anyone happened to heed my advice, barring a drastic end of the year run-up, it appears that I did a sensible job with my infrequent prediction. The four utility companies mentioned in my January 4, 2012 article have combined to return an average of negative 3.14% thus far in 2012. Now within that article, I also happened to mention five other stocks: AT&T (NYSE:T), Waste Management (NYSE:WM), Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG) and McDonald's (NYSE:MCD). So let's keep me honest here:

Jan 4th, 2012 Dividends Nov 23rd, 2012 Total Gain
T $30.58 $1.76 $34.36 18.12%
WM $32.85 $1.07 $32.36 1.75%
JNJ $65.75 $1.79 $69.56 8.52%
PG $66.63 $2.21 $69.59 7.76%
MCD $99.11 $2.10 $87.05 -10.05%
SPY $127.20 $2.08 $141.30 12.72%

Here we see that the five mentioned stocks had an average return of 5.22%, but that's not the point. I also included the SPDR S&P 500 ETF (NYSEARCA:SPY) for reference. It should be overwhelmingly underscored that I picked these dividend growth stocks at random. Within the January article, I wasn't explicitly recommending these selections. Instead, I was simply pointing out that utility stocks likely wouldn't be the best bet for someone concerned solely about 2012. The included dividend growth selections were merely demonstrating that applicable alternatives probably existed. In reality, I would hope that one considers investing to be decades rather than months such that the comparative outcomes of the above described scenarios wouldn't carry much weight anyway. It is still informational to note the result of my short-term prediction, but we still haven't reached the point.

Even though it appears that my short-term forecast happened to work out, I want to be perfectly clear that I am not writing to boast or more plainly to suggest: "look at me, I'm an utility sector psychic!" In reality, I am writing for the exact opposite reason. I'm writing to suggest that I could have just as easily been incorrect about my utility sector prediction during 2012. Let's use Chuck Carnevale's exceedingly useful F.A.S.T. Graph tool to better illustrate this point:

Above, we see the 15-year chart for Consolidated Edison. While I could have selected any of the previously mentioned utility stocks to demonstrate my point, I selected ED because it happened to have the largest total gain in 2011 and consequently, the largest decline thus far in 2012. With the F.A.S.T. graph tool, we find potential overvaluation when the black price line is above the orange line and accordingly, potential undervaluation when the price line is below the orange line. The idea is that over the long-term, price and earnings should correlate rather nicely. In fact, with just this one chart, we can eyeball the reasonableness of this fundamental assumption. So when we look to 2011, we do in fact see a sign that Consolidated Edison might have been trading slightly above a historical norm. Actually, the F.A.S.T. tool even "suggested" a more reasonable price of $53.85 for the start of 2012 rather than the $60.58 that ED was trading at in the beginning of the year.

Today, we see that the ED price and relative earnings multiple have come back towards a "more reasonable" range. But I wasn't looking to point out this short-term price convergence. Rather, I wanted to mention that it wouldn't have been inconceivable for the price of Consolidated Edison to remain above its long-term multiple for a couple of years, much like it remained below the orange line during the early 2000s. That is, even though a company might seem to be momentarily overvalued, this does not necessarily indicate that the market will immediately reflect this. Furthermore, the company's earnings could eventually "catch up" to the current share price such that your short-term prediction might never come to fruition.

My summing point in this discussion is that one should take caution with their predictions, especially in the short-term. In effect, even though it turned out to be sensible and correct, I should have been more cautious about my utility sector prediction back in January. Despite how certain one might feel about a situation, the market can over or undervalue a security for a lengthy bit of time. A secondary example of both these scenarios comes from Cisco Systems (NASDAQ:CSCO) with regard to overvaluation during the tech bubble and potential undervaluation today:

My lasting emphasis is this: one should consider their investment decisions with regard to their respective impact on your personal goals, along with the reasoned probabilities of your desired outcomes. And while it might be true that it would not have been particularly prudent to speculate that utility stocks would perform as well in 2012 as they did in 2011, that is not to say that it would have been impossible. In fact, even if you took this information into consideration, there might have been other reasons to hold such securities in the framework of a long-term mindset. Within the ideology of "practicing what I preach," my pledge to you, for better or for worse, is no more short-term price predictions.

Disclosure: I am long JNJ, MCD, T, PG, WM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.