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").

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."

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:

• So, Is Buy and Hold Dead or What?
• Long-Term Investing Doesn't Work
• Bogle on Buy and Hold and the "Long" of Long-Term Investing
• How to Invest Using the "New" Buy and Hold
• Buy and Hold Is Dead. Long Live Buy and Hold!