The Untaught Art of Developing an Investment Forecast

The following is part of the Fool's Buy and Hold series.

Guest Contributor Ken Solow, CFP, is a Founding Principal and Chief Investment Officer with Pinnacle Advisory Group, a Registered Investment Advisor located in Columbia, Md. Pinnacle provides private wealth management services for more than 500 families throughout the Mid-Atlantic region and around the world and currently manages more than $550 million in assets. Ken is a nationally recognized speaker and writer on the subject of active portfolio management, and is the author of the just-released book, Buy and Hold Is Dead (AGAIN): The Case for Active Portfolio Management in Dangerous Markets.

Investment forecasts are peculiar in that many intelligent investors believe that you shouldn't make them at all. If you have been taught the precepts of modern portfolio theory (MPT) and subscribe to the rational expectations pricing model (otherwise known as the efficient markets hypothesis), then you shouldn't make forecasts because you believe that markets are efficient and past risk premiums are likely to be earned in the future.

If you are a technical analyst who believes you "shouldn't fight the tape," then you also shouldn't make a forecast because you rely on strict adherence to trend-following rules (e.g., buy when price moves above its 200-day moving average and upward sloping 50-day moving average). In both cases, investors are relieved of the burdensome requirement of having to make a qualitative assessment of where the market will be in the future.

In light of the general agreement that forecasts should be avoided if possible, it should be no surprise that you won't find many suggestions on exactly how to develop a forecast in the investment literature. Of course, the irony of both strategies mentioned above is that they both do constitute a forecast.

Forecast denial
The typical investor using CAPM (Capital Asset Pricing Model) and MPT is making a forecast that past risk premiums will appear in the future -- therefore, stocks will outperform bonds, which will outperform cash. The trend-follower who doesn't fight the tape is forecasting future market direction by determining whether prices are trending in one direction or the other. While both techniques are quantitative in nature -- and avoid qualitative decision-making -- both nevertheless constitute a forecast.

I believe that the best investors combine both quantitative and qualitative methods for making decisions when developing a forecast. The quantitative techniques have become the "science" of investing for professional and non-professional investors alike.

It is the qualitative, or subjective, aspects of decision making that I believe represents the art of developing a forecast. It is here, in the realm of good judgment, that the best forecasts are made. Make no mistake: It is only with the tailwind of an accurate forecast that investors can hope to outperform and earn excess returns. Or to use investment-speak, it is the qualitative aspect of forecasting that most reliably leads to creating positive alpha.

I suggest that investors rely on three basic areas of investment research to help develop their forecast. Consider studying these three components when making a forecast:

  1. Market and security valuation
  2. The market cycle
  3. Technical analysis

All three areas are challenging to understand and require a good deal of ongoing study and research to properly integrate into your decision-making process. Any one of the three can tip an ambivalent forecast into a high conviction forecast.

Sector rotation
Since March, I believe the market/economic cycle has been most confusing, as investors disagree (subjective decision making) about the meaning of "green shoots" sprouting in the economy. The power of this "second derivative" rally, which has been driven by improvements in the rate of change in economic indicators that are still observably weak, has been a surprise to many.

The table below provides a simple illustration of which market sectors perform best as the economy moves from contraction to expansion. Many investors think of sectors as following a cycle as they move from contraction to expansion (and the term for following the cycle is "sector rotation").

Contraction

Consumer Staples

 

Health Care

 

Utilities

Expansion

Early Cyclicals / Interest Sensitives:

 

Financials

 

Technology

 

Consumer Discretionary

 

Late Cyclicals / Reflation Trades:

 

Materials

 

Industrials

 

Energy

 

Telecom Services

The speed and trajectory of the rally since March 9 has been record-setting, and if you squint, you can see how the proper forecast resulted in being in the right sectors at the right time. The market has rotated from non-cyclical sectors like health care, consumer staples, and utilities to pro-cyclical sectors that do well in economic expansions right on cue. Investors who thought they recognized the beginnings of an economic recovery led by positive earnings surprises in the banking sector in March have been rewarded. What has unsettled many investors is the speed of the cyclical move in the market rotation, which has taken place in the almost unbelievably short period of about eight weeks, as opposed to a more typical rotation which can take place over several years.

Back to defensive sectors?
In fact, with a few exceptions, the following chart shows the rotation from non-cyclicals, to early cyclicals (interest sensitives), to late cyclicals or "reflation trades."

 Sector

Corresponding ETF 

Jan. 1-Mar. 9

Mar. 9-Apr. 30

Apr. 30-June 8

Health Care

(NYSE: XLV  )

-17.6

11.2

5.5

Consumer Staples

(NYSE: XLP  )

-18.9

14.0

7.8

Utilities

  (NYSE: XLU  )

-21.7

14.9

4.3

Telecom

(NYSE: VOX  )

-18.4

28.5

3.8

Financials

(NYSE: XLF  )

-50.0

73.2

15.7

Technology

(NYSE: XLK  )

-14.2

31.2

5.7

Consumer Discretionary

(NYSE: XLY  )

-25.3

45.4

4.0

Materials

(NYSE: XLB  )

-20.1

42.1

6.7

Industrials

(NYSE: XLI  )

-34.4

43.1

9.3

Energy

(NYSE: XLE  )

-18.7

18.4

13.6

S&P 500 Index

(NYSE: SPY  )

-24.5

29.3

7.7

At the moment, the reflation trade remains in control, as investors reward those sectors that outperform when the dollar is weakening, emerging markets are rallying, and commodity prices are firming.

If your forecast is that the economy will not come out of recession until 2010, prepare to rotate back to non-cyclicals as the current rally runs out of gas. If you think the rally will continue, follow the market leadership. 

For more on the buy-and-hold debate:

Guest contributor Ken Solow, CFP, personally invests in Pinnacle managed accounts, and may personally own securities mentioned in this article. Ken is Chief Investment Officer of Pinnacle Advisory Group, a Registered Investment Advisor with discretion to manage client accounts that may currently own, on behalf of its clients, long or short positions in any ETF mentioned in this article. Pinnacle has complete discretion to invest in a variety of securities on behalf of its clients, subject to the constraints of client portfolio policies. Pinnacle Advisory Group and its clients are not subject to the Fool's disclosure policy, and thus are free to trade any such mutual funds or ETFs. Read more about the Fool's disclosure policy here.


Read/Post Comments (4) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 22, 2009, at 6:11 PM, dudemonkey wrote:

    It's interesting to see TMF drift so far from their "buy great companies" ideas and move more towards active trading that sends more and more money to Wall Street. Too bad.

  • Report this Comment On June 22, 2009, at 6:36 PM, tasteslikechickn wrote:

    Hey dudemonkey. It's gonna be OK, man. The TMF community is more diverse than once thought. I adhere to a blended approach where I have a portion of my portfolio dedicated to buy and hold of great companies/ETF's. And a portion dedicated to more "speculation" with small cap and cyclicals.

    Now, thanks to MFPro, I can explore options as a way to profit in any market and hedge risk.

  • Report this Comment On June 22, 2009, at 7:15 PM, dudemonkey wrote:

    You're right. Things have certainly changed from the long bull market and strategies should update, also.

  • Report this Comment On July 27, 2009, at 12:27 AM, Khizhim wrote:

    o Ken Solow:

    I couldn't be more interested in the correlation of stocks' market-price cycles to the stages of the economic cycle, so I greatly appreciate this essay, but I wish you'd explained yourself more fully.

    1. I assume the first table lists the market sectors which "top" during the respective stages of the economic cycle. Is that correct? Do stocks in those "sectors" tend to reach their highest values of each market-price cycle during those economic stages? (I'm assuming the defensive sectors barely cycle at all.) You only said the sectors which you associated with various stages "perform best" during those stages.

    2. You said "you can see how the proper forecast resulted in being in the right sectors at the right time. The market has rotated from non-cyclical sectors like health care, consumer staples, and utilities to pro-cyclical sectors that do well in economic expansions right on cue."

    Wouldn't the "cues" normally be hints of imminent advancement of the business cycle from one stage to another, or wouldn't they at least suggest changes in business conditions which could materially affect the profitabiltiy of companies? You do suggest this by saying, "Investors who THOUGHT they recognized the beginnings of an economic recovery led by positive earnings surprises in the banking sector in March have been rewarded." (You don't mention the FASB Mark-to-Market accounting rule changes, the psychological effect of the reinstatement of the uptick rule, major balance sheet purchases by the Fed, coordination by central banks globally, and other factors which don't seem to relate directly to normal business cycle events.)

    Investors who THOUGHT they recognized the beginnings of an economic recovery *were* rewarded, but, as you also point out, the market quickly shifted its favor from interest-rate-sensitive, early-cycle sectors to late-cycle "reflation" sectors. Can't it be said that this "sector rotation" occurred far too rapidly to have been accurately correlated to actual changes in economic conditions? Economic conditions couldn't possibly have changed as quickly as market participants thought.

    Wouldn't traders who fully understand sector rotation have recognized these rapid changes of valuation as mere evidence of market volatility? The market was reacting with pathological skittishness to limited information as soon as that information became available. I agree that no one should attempt to "fight the tape" but isn't it obvious that most of the assumptions about economic conditions which drove the market were WRONG in the sense that the economic changes which market participants THOUGHT they saw HADN'T occured? Wouldn't competent users of sector rotation have seen that the equities market was extremely volatile and that it was veering off in contradictory directions so quickly that commitment might be too risky?

    3. It looks like you've only boldfaced certain price-change percentages in your second table in lieu of providing a more complete explanation of the sector rotation which you say is documented by your second table. Are you saying that non-cyclical, defensive sectors such as Health Care, Consumer Staples, Utilities, and Telecomm tended to be favored before the market rally began on 3-10-09, when many observers feared the entire system would melt down? Are you then saying that reaction of market participants to the hints of "the beginnings of an economic recovery" which provoked the rally in early March caused the market to value interest-rate-sensitive, early-cyclical sectors such as Financials, Technology, and Consumer Discretionary? Was the final rotation (which you say was to late-cycle, "reflation" sectors) to Materials, Industrials, and Energy?

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 926304, ~/Articles/ArticleHandler.aspx, 10/26/2014 3:51:49 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement