This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Unknown Unknowns: Predicting Stock Trends

NEW YORK (TheStreet) -- How significant to you is it that Wall Street strategists have lowered their equity market forecasts from mid-double-digit returns for 2013 to single-digit returns for 2014?

It turns out that those forecasts are worth a lot less than you might think.

Equity-return modeling generally incorporates estimating the average trend in economic factors, and then assigning a price multiple to that future trend. (The new price multiple is almost always anchored within 1 or 2 of the current multiple). To add some complexity, in the recent bull market leading up to the 2008 to 2009 financial crisis, Wall Street firms opened up this single-point price target. Some major firms now offer binomial path outcomes instead -- a bull case and a bear case scenario, with a probability assigned to each.

Most people -- including the strategists themselves -- focus on such important details. But these probabilities could be risk-adjusted so that the future price can be extrapolated using a risk-neutral investor approach, or the actual probabilities could stay in absolute terms and an appropriate risk rate could be used to determine the future price target.

Leaving this whole complication aside, the point here is that the major source of uncertainty among Wall Street forecasters remains on macro calls of what the price multiple would be on the future earnings trend. Are they generally optimistic or generally pessimistic? This can account for a large explanation of the generally double-digit difference in the higher year-end targets versus the lower year-end targets. If the current multiple is, for example 15, and a pessimist anticipate a 0.5 change and an optimist estimated a 2.0 change, then the 1.5 difference is 10% of the original 15. This is an important idea, as we uncover an additional 12%-or-so spread that risk mis-timing forces onto things.

The core middle-of-the-pack entered this year looking for a single-digit return in 2014. Of course, as any long-term strategist outside of Wall Street would note, the end of 2014 is quite an arbitrarily brief period of time. And these net returns just take into account a long-run average amount of risk within that period. Of course this masks an ugly truth about the nature of risk, which is that it doesn't occur in the same way and time frame as the economic return factors that monopolize the intellectual demands of Wall Street analysts.

Now let's assume that the major risks implicit in each calendar year are one 10% correction and two 5% corrections -- 20% annual total, 40% biennial.

But in reality, these corrections will happen when they choose. They are calendar agnostic and do not conform to the smooth parameters of economic growth extrapolations.

Looking at the probability of the risk convolutions for any one given year, we can suggest the other combinations that can play out in our hypothetical scenario of 40% biennial risk. Namely look at these other examples, which could occur in 2014 and 2015 (including in reverse order, so that either year could be Year A, and the other be Year B). Any event that shifted from Year A, to Year B, is italicized. The probabilistic weight is provided above each combination. The ordering of the risk events in any given year is irrelevant.

So if there is 40% biennial risk, then that could be distributed as follows.

1/4 weight
Year A --> -10%, -5%, -5%
Year B --> -10%, -5%, -5%

1/3 weight
Year A --> -10%, -5%
Year B --> -10%, -5%, -5%, -5%

1/4 weight
Year A --> -5%, -5%
Year B --> -10%, -5%, -5%, -10%

1/6 weight
Year A --> -10%
Year B --> -10%, -5%, -5%, -5%, -5%

1 of 2

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!

Markets

DOW 18,053.71 +23.50 0.13%
S&P 500 2,088.77 +6.89 0.33%
NASDAQ 4,806.8590 +33.3870 0.70%

Brokerage Partners

Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs