Over the last few weeks, I have been asked repeatedly to publish my best guess as to where the market will wind up by the end of 2019. Here it is: “I don’t know.” The reality is that we can not predict the future. If it was actually possible, fortune tellers would all win the lottery. They don’t, we can’t, and we aren’t going to try. However, this reality certainly does not stop the annual parade of Wall Street analysts from pegging 12-month price targets on the S&P 500 as if there was actual science behind what is nothing more than a “WAG.” (Wild Ass Guess). The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been
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Over the last few weeks, I have been asked repeatedly to publish my best guess as to where the market will wind up by the end of 2019.
Here it is:
“I don’t know.”
The reality is that we can not predict the future. If it was actually possible, fortune tellers would all win the lottery. They don’t, we can’t, and we aren’t going to try.
However, this reality certainly does not stop the annual parade of Wall Street analysts from pegging 12-month price targets on the S&P 500 as if there was actual science behind what is nothing more than a “WAG.” (Wild Ass Guess).
The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.
Ed Yardeni published the two following charts which show that analysts are always overly optimistic in their estimates.
This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average.
Most importantly, the reason earnings only grew at 6% over the last 25 years is because the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term…remember that.
The McKenzie study noted that on average “analyst’s forecasts have been almost 100% too high” which leads investors into making much more aggressive bets in the financial markets which has a general tendency of not working as well as planned.
However, since “optimism” is what sells products, it is not surprising, as we head into 2019, to see Wall Street once again optimistic about higher markets even after massively missing 2018’s outcome.
But, that was so last year.
For 2019, analysts have outdone themselves on scrambling to post the most bullish of outcomes that I can remember. Analysts currently expect a median projected return of 23.66% from the 2018 close.
No…seriously. This is what Wall Street is currently expecting despite the fact that foreign and domestic economic data is weakening, corporate profit growth is likely peaking, trade wars are heating up and the Federal Reserve is tightening monetary policy. As Greg Jensen, co-chief investment officer of Bridgewater Associates, the biggest hedge fund in the world, recently stated:
“The biggest theme developing is that you are going to have significantly weaker growth, near recession-level growth in 2019, based on our measures, and the markets are generally not pricing that in.
Although the movement has been in that direction, the degree of [ the market’s decline] is still small relative to what we are seeing in terms of the shifts in likely economic conditions. 2019 will be a year of weaker growth and central banks struggling to move from their current tightening stance to easing and finding it difficult to ease because they have very little ammunition to ease.”
All of this should sound very familiar if you have been reading our work over the past year.
“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”
This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting gimmicks to either increase or depress, earnings.
“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb. What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.”
Since company executives are highly compensated by rising stock prices, it should not be surprising to see 93% of the respondents pointing to “influence on stock price” and “outside pressure” as reasons for manipulating earnings.
Note: For fundamental investors, this manipulation of earnings skews valuation analysis particularly with respect to P/E’s, EV/EBITDA, PEG, etc.
This was brought to the fore in 2015 by the Associated Press in: “Experts Worry That Phony Numbers Are Misleading Investors:”
“Those record profits that companies are reporting may not be all they’re cracked up to be.
As the stock market climbs ever higher, professional investors are warning that companies are presenting misleading versions of their results that ignore a wide variety of normal costs of running a business to make it seem like they’re doing better than they really are.
What’s worse, the financial analysts who are supposed to fight corporate spin are often playing along. Instead of challenging the companies, they’re largely passing along the rosy numbers in reports recommending stocks to investors.“
Here were the key findings of the report:
- Seventy-two percent of the companies reviewed by AP had adjusted profits that were higher than net income in the first quarter of this year.
- For a smaller group of the companies reviewed, 21 percent of the total, adjusted profits soared 50 percent or more over net income. This was true of just 13 percent of the group in the same period five years ago.
- From 2010 through 2014, adjusted profits for the S&P 500 came in $583 billion higher than net income. It’s as if each company in the S&P 500 got a check in the mail for an extra eight months of earnings.
- Fifteen companies with adjusted profits actually had bottom-line losses over the five years. Investors have poured money into their stocks just the same.
- Stocks are getting more expensive. Three years ago, investors paid $13.50 for every dollar of adjusted profits for companies in the S&P 500 index, according to S&P Capital IQ. Now, they’re paying nearly $18.
But, that is just a guess.
As I said, I honestly “don’t know.”
What I do know is that I will continue to manage our portfolios for the inherent risks to capital, take advantage of opportunities when I see them, and will allow the market to “tell me” what it wants to do rather than “guessing” at it.
While I read most of the mainstream analyst’s predictions to get a gauge on the “consensus.” This year, more so than most, the outlook for 2019 is universally, and to many degrees, exuberantly bullish.
What comes to mind is Bob Farrell’s Rule #9 which states:
“When everyone agrees…something else is bound to happen.”