In market-forecasting, longer horizons help
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By: Kevin DiCiurcio
Every new year brings a cavalcade of market and economic forecasts. Many of the issuers are so bold as to focus on the single calendar year at hand. They purport to tell investors where, for example, the S&P 500 Index will stand at the close of trading on December 31.
Meaningless and futile are the most charitable descriptions I can apply to such forecasts.
Market forecasts: Better to consider longer periods
To be sure, I do not want to impugn all efforts to see the financial future. Indeed, I make my living forecasting market returns. Specifically, I oversee research into forecasting and the operation of the Vanguard Capital Markets Model®, which powers the view on asset classes we present in our annual economic and market outlook.
But if you spend any time considering market forecasts—ours or anyone else’s—you should understand that there is a relationship between their horizons and their accuracy. Longer-term outlooks are more accurate.
Consider Wall Street forecasts of calendar-year S&P 500 Index price changes over the last dozen years. As shown in the chart, reality almost always defies such short-term prognostication.
The futility of short-term market forecasts
Analyst forecasts of 1-year S&P 500 Index levels versus actual returns
Notes: The chart reflects a varying number of forecasts, ranging from a low of 11 for 2011 to a high of 22 for 2019, tracked by Bloomberg. Each was issued in December of the preceding year. Because they were made for the closing level of the S&P 500 Index, they were price-only—not total return—estimates, which would include the effects of dividend payments.
Sources: Vanguard and Bloomberg.
Most notably, in nine of the 12 years between 2011 and 2022, the index’s actual return fell outside the generally wide range of analysts’ estimates. In all four years when stock prices either declined or were flat, even the most pessimistic analyst proved too optimistic. In five years, the opposite occurred: Even the most optimistic analyst underestimated the extent of stocks’ gains.
Wall Street knows that stocks are risky, right?
While often missing the proverbial dart board, Wall Street analysts’ 12-month forecasts underrepresent the downside risk of stocks. None of the median forecasts—and just 13 of the 198 underlying forecasts in our sample, or less than 7%—anticipated falling share prices.
As it turned out, stocks declined in three of the 12 years and were flat in a fourth year. Such outcomes should not surprise investors, let alone Wall Street analysts, because stock prices have fallen roughly 25% of the time over the longer term. The S&P 500 Index recorded negative total returns in 26 of the 97 calendar years starting in 1926.
The few declines that analysts envisioned were modest to a fault. The largest forecast was just –7.7%. Stocks fell roughly three times as much in 2022, and the index’s 26 calendar-year losses since 1926 averaged –13%.
So much for one-year stock-price forecasts.
Why Vanguard market forecasts consider 10-year horizons
We seek to approach the future with the humility it deserves. That’s one reason why the hallmarks of Vanguard market forecasts are, first, our longer-term orientation and, second, our focus on the entire probability distribution of outcomes.
We do offer point forecasts—the median results of our simulations of potential returns—but we acknowledge the uncertainty of how markets will perform by presenting them as the central tendencies of estimated ranges of likely outcomes. For example, we expect large-capitalization U.S. stocks to return 2.7%–8.5%, annualized, over the next decade.1 Our median estimate is 5.7%, annualized.
In forecasting, valuations matter
There’s no magic in our selection of 10 years as our standard forecast horizon.2 The key is taking a long enough view of markets to ensure that our valuation-based approach can be reasonably accurate. We recognize that, over longer periods, unusually high or low valuations tend to revert toward a fair value level consistent with prevailing inflation and interest rates.
Other key elements of our market forecasts include sovereign-debt yields curves and credit spreads—the marginal yields that corporate and other bonds offer over and above sovereign debt as compensation for their higher risk.
The accuracy of Vanguard market forecasts
The chart below shows that actual market returns have tended to fall inside the range of our forecast outcomes. Our overriding concern is being as accurate as possible about the performance of globally diversified, balanced portfolios—those comprising stocks and bonds—because we’ve long argued that most investors should maintain such portfolios.
We’re proud of our forecasts’ accuracy
Forecast versus actual 10-year annualized returns for globally diversified, balanced portfolios
Notes: The chart shows the actual 10-year annualized return of a 60/40 stock/bond portfolio compared with the VCMM forecast for the same portfolio made 10 years earlier. For example, the 2011 data point at the beginning of the chart shows the actual return for the 10-year period 2001–2011 (solid line) compared with the 10-year return forecast made in 2001 (dotted line). After 2022, the dotted line is extended to show how our forecasts made between 2013 and 2022 (for the 10-year periods ending between 2023 and 2032) are evolving. The interquartile range represents the area between the 25th and 75th percentile of the return distribution. The portfolio is 36% U.S. stocks, 24% international stocks, 28% U.S. bonds, and 12% international bonds.
Source: Vanguard calculations, as of September 30, 2022.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of September 30, 2022. Results from the model may vary with each use and over time.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
While the accuracy of our calls on individual asset classes obviously could affect the accuracy of our outlook for diversified, balanced portfolios, we’re not especially concerned with any one asset class. Boldly telling the world where the S&P 500 will stand 12 months from now may capture headlines, but we’re more concerned with giving investors realistic expectations.
Armed with realistic expectations, investors and their advisors can lay better plans for meeting long-term financial goals. That’s something that everyone, from Wall Street to Main Street, should want to see.
All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss. Investments in bonds are subject to interest rate, credit, and inflation risk.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.