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Which Three Factors Can Predict the Future?


Profit and loss can be seen from a long way off.

Recently, our office received an unwanted fax. Perhaps you get these also. An oracle offered to predict the future. I often see people on the train flipping through The New York Post until they find the horoscopes. Soothsayers and mediums – does anyone take them seriously? Then again, if one could predict the future, it would lead to considerable wealth.

"You can't predict the future" is a widely held myth. It is true, but it does not stop people from trying.

Some management and investment companies claim to see the future. Management consultants decree strategic futures; five years is common. Market research studies predict consumer behavior. Regression analysis shows which stocks and bonds will perform best.

Each December and January feature numerous articles on what to invest in for the upcoming year. All of these efforts are taken very seriously. Investors pounce on well-crafted predictions. In the first few months of 2012, US mutual funds have seen a whopping $95 billion flow into bond funds, while $9 billion has departed equity funds. ETFs and international equity are showing a strong money flow while domestic equity is fading. This will change as new predictions roll out.

Maybe it is possible to predict the future. Since it is our sworn duty to bust all myths – especially those with relevance to business - here is our effort to expose the incorrectness of the you-can't-predict-the-future myth.

You can do a pretty good job of foretelling the future by carefully observing the past. Take Starbucks (SBUX) and Jet Blue (JBLU). These former darlings were on a course to outperform Apple (AAPL) – at least according to their ardent observers. Before the recession, investors were licking their chops over Starbucks' strategic plan to triple its locations.

So, at least let's agree that the past provides some ability to predict the future. This peek behind the dark glass does not last forever, but it does offer a glimpse into the next few years barring the unexpected. Jet Blue and Starbucks stumbled over the unexpected.

One of the best examples of the power of the past to predict the future lies in portfolio theory. Simply stated, investors should Buy and Hold; Hold for the Long Term.

The most successful investors – Warren Buffett being the prime example – adhere to this traditional wisdom. So, if a company has produced profits consistently, is well managed, and operates in a stable industry, it should continue to perform well. IBM (IBM), GE (GE), Exxon Mobil (XOM) and others form the basis of many successful portfolios. Similarly, US government bonds will continue to provide little risk.

Portfolios minimize risk. While blue chips form the basis of sound investing, hedges recognize the inherent risk in all investments and provide a different kind of portfolio anchor. Art, gold, and agricultural land, which tend to hold their value in a down market, may appear alternately risky or mysterious, but they moor a portfolio of stocks and bonds to help them ride out stock market hurricanes.

Within the fixed income world, predicting the future generates enormous profit. Apart from straight up portfolio thinking – balancing risk and return - here is an insight into making a big profit in fixed income. While US government securities carry low risk and low return, unrated (junk) bonds offer greater return; of course, it comes with higher risk. Few portfolios carry more unrated bonds than government or corporate rated instruments. A few investors put all their eggs in the unrated basket and succeed wildly. Can they see through the mist of the future?

Junk bond investors succeed because they can predict the future.

Yield Differentials In the case of an unrated bond, the crystal ball act does not come from merely watching the point spread between government Treasuries and high yield bonds as most investors do. That only tells you the market's current sense of risk and reward. These yield differentials may change significantly at short notice. The future yield differential derives from three known factors: defaults among unrated bonds, market liquidity, and the soundness of the debt project. Through 2011, the bond default rate was in the 3% range, way down from 2009. When the market caught on, the yield differential shrank. Knowing the low default rate allowed some investors to capitalize on unrated bonds.

Liquidity The second factor, liquidity, also plays a key role. Money is available and rates remain low.

Soundness of Debt The most powerful means of predicting the future in the unrated arena concerns the soundness of the debt project - the third reason. In a difficult economy, borrowers lack the cheerleader-level enthusiasm of a bull market. Everyone is happy; money flows; premiums for an acquisition stagger the imagination. In a bear market, the reverse is true. Money is tight; euphoria disappears. Only a sound project is approved by the belt-and-suspenders management and their green eye shade investors. The low level of defaults occurs because junk bond issues in a bad economy are likely to be sound. These three factors can be seen and can predict the future.

But one cannot predict specific events or future trends. Even so, profit and loss can be seen a long way off.

Considering these arguments, we might think twice about that person turning over tarot cards. She or he might be on to something. Stay tuned – another myth will be "busted" next month. Please comment on this myth and let us know which myths need exposure.

This article was written by Michael McTague.

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