As the New Year begins, many well-known stock market personalities have posted their guesses on where the Dow Jones Industrials (DJINDICES:^DJI) will end 2014. As entertaining as these predictions might be, the terrible track record that Wall Street's finest have in actually making accurate estimates should convince you once and for all that relying on those predictions is a potential ticket to disaster.
The problem with predictions
In general, market predictions about the stock market fall into two general categories. Among major Wall Street firms, you'll typically find predictions that reflect general bullishness or bearishness without taking extreme positions one way or the other. For instance, coming into 2013, forecasts from six well-known investment banks called for returns on the S&P 500 of between 0% and 12%, according to figures compiled by PunditTracker. That put UBS (NYSE:UBS) squarely in the bearish camp even with its expectations of flat performance, while Bank of America's (NYSE:BAC) Merrill Lynch ended up looking like the bull of the group even though its forecast underestimated the S&P's actual gains by more than half.
In the other category, you can always expect to see some outlandish expectations. After five years of a bull market, most of these outlier predictions aim toward the downside. For instance, in 2013, financial author Harry Dent predicted that the Dow would fall to 5,000. The bad call was just the latest in a series of failed bearish predictions for Dent after the 2011 publications of his book The Great Crash Ahead: Strategies for a World Turned Upside Down. At the same time, though, some bullish calls from early 2013 look like they have a chance of coming true now, with JPMorgan (NYSE:JPM) analyst Thomas Lee having predicted that Dow 20,000 might be just four years away. With the Dow at levels closer to 13,000 at the beginning of 2013, that call sounded a lot more aggressive than it does now with the Dow near 16,500 -- even though it only implies annual average returns of about 11%.
Understanding business motivations
Obviously, when you look at any prediction, you should consider the motivations of the company or person making that prediction. For UBS, Merrill Lynch, JPMorgan, and other Wall Street analysts, those making predictions are trying to put their clients at ease about the investment decisions their respective companies recommend while also setting themselves apart as being better at making accurate calls about the market. Shareholders in those companies should want them to be smart about their predictions, avoiding going out on a limb that can bring scorn from the investing community and have a negative impact on their business. Yet few clients hold those banks accountable to their specific predictions, especially when their mistakes actually lead clients to make more money than they would have otherwise. Similarly, it makes sense for those who've written books about their market positions make predictions supporting their conclusions, as it whets readers' appetites to encourage them to pick up a copy of their books.
Before you look at any prediction, it's important to look back at the track record of whoever made the prediction. Yet even that can be misleading, as just because someone has been right before doesn't mean they'll be right again, and bad calls in the past might well turn into good ones for the future. In the end, your best move with predictions is to look at them as entertainment, to draw your own conclusions from their reasoning, and to try to come up with your own analysis of where the Dow and the broader stock market is likely to move in the years to come.