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Why Investment Strategists have the Toughest Job on Wall Street

William Hester, CFA
January 2004
All rights reserved and actively enforced.

If everyone is allotted 15 minutes of fame, Wall Street Strategists cash in a chunk of theirs every January. That's when they're asked to recommend how much investors should put into stocks, bonds, and cash. Their annual forecasts have recently been featured in USA Today, Barron's and Bloomberg.

On average this group of forecasters expects the market to climb 4 percent this year. Ten of 12 predict higher stock prices, according to USA Today. Prudential's Ed Yardeni, the most optimistic strategist, thinks the market will climb 17 percent. Merrill Lynch's Richard Bernstein says stocks will drop 9 percent.

How much faith should we put in these forecasts? First, consider the difficulty of their profession.

Much like economists, strategists forecast because they're asked, not because they know. Predicting the stock price of a single company a year from now is an extremely challenging task. Analysts begin by forecasting the company's revenue and then its costs: labor, inventory, research, options, pensions, healthcare, interest, and taxes. From these they create an earnings forecast and then guess the multiple investors will pay in a year for those profits.

Now multiply that process by 500 to forecast Standard & Poor's most famous index. Understandably, the results haven't been good. Most of the strategists missed the bear market completely and not one of them forecasted its depth and duration. Their ability to recommend which asset class to overweight has also been limited.

According to a study done by Bing Xiao, a Bloomberg News statistician, the performance of the recommendations of six Wall Street strategists from January 1997 through March 2001 trailed the return of a static allocation. 1

It's a short period, but one where switching between asset classes would have added value. The S&P 500 was up 31 percent in 1997, 27 percent in 1998, and 20 percent in 1999. In 2000, stocks fell 9 percent and then another 10 percent through March of 2001. Bonds were nearly as volatile. They had double-digit gains in 1998 and 2000, and dropped over 8 percent in 1999.

Not surprisingly, the six were unable to navigate the volatile returns. Two of the four strategists turned bearish during 1998's Asian crisis only to have the market gain 40 percent over the next year. After the market peaked in 2000, four of the strategists stuck to their bullish views in the face of declining stock prices (and would continue to stick with them throughout the bear market).

The best performing recommendations climbed 8.9 percent a year; the lowest rose 7.1 percent. An unchanged allocation of 60 percent stocks and the rest in bonds gained 10.1 percent.

This isn't a harsh criticism of strategists. Forecasting is difficult work.

It's also dangerous work. Of the five individual strategists in the study only one is still at their job, Goldman Sachs' Abby Joseph Cohen. (Salomon Smith Barney, a unit of Citigroup and the sixth in the study, chose its recommendations by committee during that time.)

From 1997 through 1999, the investment strategists at Salomon Brothers, Oppenheimer, and Merrill Lynch - all staunchly bearish - stepped down from their positions or left their firms as the market moved higher (see chart).

When stocks turned down, it was the bulls who found themselves out in the cold. In the two years ending 2002, the strategists at Merrill Lynch, Lehman Brothers and CSFB some of the most bullish among their peers were fired. Lehman Brothers and CSFB delivered pink slips to their optimistic strategists in late 2002, right at the market's trough (add that to your "signs of a bottom" list).

So strategists not only have to forecast where stocks or bonds are heading, but they're given a time limit for being wrong. This doesn't leave much room for bold calls.

With the stock market's explosive gain last year, the mostly bullish strategists are on safer ground. The two bears of the group expect the market to drop by single digits. Smith Barney's Tobias Levkovich predicts higher interest rates will take the S&P 500 down 8 percent. Merrill's Bernstein started the year expecting the market to drop 20 percent. Last week he became less bearish, forecasting a 9 percent decline.

Ironically, one of Bernstein's most reliable sentiment indicators is the outlook of Wall Street strategists. It's a contrary indicator: when their optimism grows, his outlook on stocks dims. Bernstein's change doesn't affect his own model's reading, though, because he's become less bearish rather than more bullish. Still, the biggest bear becoming less pessimistic is an interesting turn of events in an already optimistic environment.

Strategists are an important part of the Wall Street research mix. They have access to large amounts of data on valuation, sentiment, and corporate health. When analyzed properly this information can help investors find opportunities and avoid risk. But predicting where the stock market will be a year from now? That's too much to ask from anyone.

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1 Bing Xiao, A Balancing Act, Bloomberg Personal Finance Magazine, June 2001.


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