Swedroe: Ignore Forecasters At All Costs

The historical evidence shows us that, in the long run, a thoughtfully designed, diversified portfolio of passively managed funds typically beats the performance of all but a few active managers. And while it’s simple to structure such a portfolio, it’s not easy to maintain.

All too often, emotions—such as greed or envy in bull markets, and fear or panic in bear markets—can cause even well-developed financial plans to end up in the trash heap.

Investor discipline gets tested not only by market movements, but by the prognostications of financial “gurus” hyped by the financial media. Their goal is to keep your attention, and they make money selling air time.

There’s a lot of evidence from academic research showing there really aren’t any reliable market forecaster, and I can’t forget the admonishment of perhaps the most admired investor of all time, Warren Buffett, to ignore all forecasts because they tell you nothing about the direction of the market.

That said, I still spend a lot of my time as the director of research for the BAM Alliance having to convince investors to ignore the predictions of pundits such as Jeremy Grantham.

I should point out that I really like reading Grantham’s investment letters. I find them insightful and filled with interesting information. And I’ve also had the pleasure of hearing him speak at conferences.

Grantham Has Been Very Wrong

While I have great respect for his writings and ideas, I totally ignore his advice when it comes to trying to time the market because I believe that particular advice has no value whatsoever.

For the last several years, Grantham has been among the many gurus warning investors both about high valuations (P/E ratios) and high profit margins. Basically, the warning is that both these metrics are currently at high levels and will very likely revert to their historical means, producing either a big bad bear market or a decade of lousy returns.

Unfortunately for the investors who listened to Grantham’s sage counsel, the markets have continued to ignore him. For example, while the long-term average of the Shiller CAPE 10 has been about 16.6, it’s now been above 20 since 2010. That’s what has caused Grantham to warn about reversion to the mean.

At the start of January 2010, the Shiller CAPE 10 stood at 20.5. By the following year, it had risen to 23.0. At the start of 2012, it stood at 21.2, and climbed to 21.9 by the start of 2013 and 24.9 by the start of 2014. As I write this on Dec. 5, the Shiller CAPE 10 continues to defy Grantham’s call for reversion to the mean and stood at 27.2.

After rising 16 percent in 2012, the S&P 500 rose another 32.4 percent in 2013, and was up almost another 14 percent year-to-date. I would add that, while the Shiller CAPE 10 is at relatively high levels, the current P/E ratio doesn’t look so high.

Different Perspective On P/E

According to Edward Yardeni, the current forecast for S&P 500 earnings for 2014 is about $118 per share. That’s a P/E ratio of about 17.5. While that’s above the historical average, it’s not that much above it.

And who is to say that the historical average is really the correct figure to which P/E ratios will or should revert over the long term? There are many good arguments for justifying a higher P/E ratio. For example, stronger regulatory regimes make equity investing less risky, and so lead to lower required risk premiums.

In addition, the much lower trading costs we are now experiencing are another argument for a lower equity risk premium. And the wealthier a country becomes, the lower the equity risk premium tends to be.

Costly Mistakes

As I mentioned previously, Grantham has also been warning that profit margins are well above historical levels, and are thus unsustainable. As far back as in 2011, Grantham was warning that margins were freakishly high.

And in late 2011, Grantham’s colleague, GMO Director of Asset Allocation Ben Inker, put the fair value of the S&P 500 Index at between 950 and 1,000, compared with the 1,158.67 at which it had actually closed.

At the time, Inker warned that the implication for the stock market was ugly, again because earnings were unsustainably high. Roughly three years later, the market is up about 80 percent. And how are profit margins now? They’re actually higher as well, having risen from just less than 10 percent to slightly more than 10 percent.

Now it’s possible—if not very likely—that, like a broken clock, Grantham and the other gurus who scared investors away from the markets based on fears surrounding high valuations and high profit margins will eventually be correct in their forecasts.

However, investors who paid attention to them have incurred large opportunity costs in the meantime. In my opinion, investors are better served by simply adhering to their well-thought-out plans. When valuations and margins rise, you’ll still get to take some chips off the table through the discipline of rebalancing.

Ignore The Clarion Cries

Warren Buffett said: “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.” Ignoring the clarion cries from “gurus” such as Jeremy Grantham (and Dr. Doom himself, Marc Faber) is perhaps the hardest part of being a successful investor.

That said, the bottom line is that, no matter how hard maintaining discipline can be, it is still much easier than trying to predict which active managers will randomly beat the approach of building a globally diversified portfolio of passively managed funds and staying the course, rebalancing as required.

That’s why author Charles Ellis called active investing the loser’s game—the surest way to win is not to play.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.