It is always tempting to try and predict the future. Indeed, many investors are currently relying on bullish company earnings forecasts when deciding whether to buy a specific stock. This may help them to justify rich valuations that have become increasingly prevalent in today's stock market.
In my opinion, the accuracy of such forecasts is more likely to be based on luck rather than judgment. There are an infinite number of factors that can impact on the prospects for any stock. This means that seeking to second-guess them may represent an inefficient use of time.
Instead, focusing on information that is not reliant on forecasts could be a more productive investment strategy. It may provide a more relevant guide to the risk/reward opportunity presented by a specific stock, or the wider market.
The present versus the future
Investors have an array of financial information and data available that does not depend on the accuracy of forecasts. It could be a more reliable means of assessing the merits of investment opportunities.
For example, company fundamentals provide an insight into a stock's risks. A firm's balance sheet contains useful information such as its debt levels and access to liquidity, while cash flow statements offer guidance on its financial performance. Comparing these figures to a company's sector peers may highlight the different levels of risk present in a specific sector.
Meanwhile, company valuations that use historic numbers are not subject to forecasting errors. A stock that has a lower price-earnings ratio than its industry peers may offer a wider margin of safety. Likewise, if the stock market's valuation is high compared to its long-term average when using historic figures, it could signal that investors have become overly optimistic about its prospects.
Optimism in today's market
The S&P 500's 70% rise since March 2020 means that many investors are currently upbeat about the future. This can cause them to be less sceptical about forecasts than would normally be the case. They may be more willing to accept expectations as a given result.
At such times, it can be useful to listen to value investors who have experienced similar conditions many times during their careers. One such investor is Oaktree Capital cofounder Howard Marks (Trades, Portfolio), who once stated:
"Look around, and ask yourself: Are investors optimistic or pessimistic? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous? All of these things are important, and yet none of them entails forecasting. We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future".
Investing in today's bull market
In my view, Marks' statement is highly relevant in today's stock market environment. Just because share prices have risen in the recent past does not influence their future performance in any way, shape or form. Previous bear markets, such as the 2020 crash, came out of nowhere. They can be sparked by unforeseen events that, by their very nature, are impossible to forecast.
Since no bull market in history has ever lasted forever, there is an innate danger in extrapolating recent trends into the future. Therefore, using present-day observations to apportion capital could represent a more efficient strategy than relying on forecasts.
Read more here:
- Li Lu: Forget Volatility, the Potential for Permanent Loss of Capital Is What Matters
- Benjamin Graham on the Dangers of Momentum Investing
- Seth Klarman on the Benefits of Dollar Cost Averaging
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