Would You Like to Make an Investment/Bet?

We have at times equated investing to gambling. While even the best gamblers count on a certain amount of sure things, they know there are always uncontrollable factors that ultimately determine the outcome. Investing has its own set of craps shots, particularly when investing for the short-term.

In the short run, the direction and pace of economic activity often proves to be unpredictable. Few, if any, investors or economists forecast the great speedup in economic growth during late 1999 - early 2000, the abrupt business slowdown that occurred late last year, or the recession that might be developing now.

Why this uncertainty? Basically it is because so many variables influence swings in business activity, and their relative impacts differ from one economic period to the next. In contrast to the unpredictability of short-term economic moves, the long-term outlook for business activity is quite certain: gross domestic product will grow. So no problem is forever.

The short-term pattern of corporate profits is even more uncertain because of:

1. changing economic conditions (boom, recession, or something in between);
2. varying rates of overall inflation and swings in specific costs (like energy, whose huge price increases are squeezing many companies' earnings now); and
3. competitive factors (such as the worldwide overcapacity in the auto and personal computer industries that has pushed down selling prices and profit margins sharply in the past year, as demand for those products has slackened in a slowing economy).

One fact about individual companies' performance is that there are good, bad, and indifferent businesses, and firms in various industries usually perform well, poorly, or so-so because of the basic characteristics of their industries.

Forecasting earnings per share is a crucial part of company analysis and even in these days of "managed" earnings, that is hard to do accurately when business conditions change, as they often do. In all but a few very stable businesses, the conditions affecting profits can shift from one quarter to the next, and one year to the next.

Investors did not see this in the late 1990s when the U.S. economy was experiencing unusually consistent, strong growth. Forecasting near-term earnings was easy then, but in the past 6-12 months, as less favorable business conditions have developed, predicting quarterly earnings has returned to its normal degree of difficulty and there have been lots of negative surprises. Most of these have caused red faces for analysts and sharp stock price declines. As with the general economy, many variables influence short-term earnings and it is often impossible to forecast the impact of all of them properly.

In another area of forecasting, it has proven virtually impossible to pick the ultimate winners in new businesses, especially in the fast-moving, high-risk technology sector. Most frequently, in fact, the early leaders have fallen by the wayside.

Although economic forces are much more powerful than political forces in our self-correcting free market system, political factors can be influential at times. But they are usually quite unpredictable. Who would have forecast that President Clinton would have pushed so hard and successfully to establish the NAFTA trade agreement, or that his wife's proposed health care plan would have been a quick, complete flop, or that President George H. Bush would raise taxes. Even he did not feel he would do that.

It really is uncertain what future political forces will influence the economy in the U.S. or most other countries. Fortunately, in the U.S. most political actions affect just a handful of individual industries, usually through regulatory action (restrictions on drilling for oil and gas, California's attempted deregulation of electric utilities, prospective drug benefits for Medicare participants, etc.). These can be important for a while for the affected industries, but not significant for the overall corporate scene.

One area where government (supposedly a non-political sector of government) plays an important role is management of monetary policy by the Federal Reserve Board. Changes in interest rates and the availability of credit can have a major short-term impact on the economy and the financial markets. Often the Fed's moves can be predicted accurately, but there have been notable exceptions that surprised investors.

Over the long run (measured in decades), the stock market is usually very predictable. As has been demonstrated many times, the long-term trend of stock prices (both the overall market and most individual stocks) is upward, in close parallel with the growth of earnings per share. That is as certain as anything about equity investing, for the simple reason that most companies' earnings do grow and the more money a business earns, the more it is worth.

But in the short term, stock prices are totally unpredictable, because shifts in investor moods come quickly and they're very powerful, often carrying stock prices to extremes. This is why focusing on valuation of stocks is so crucial. Valuation measures investors' moods and can thus tell us where a stock is located on the psychological spectrum. That, in turn, indicates what the risk/reward potential of the stock is -- but not where it is going tomorrow, or next week, or even next year.

The real gamble of investing is that random, totally unexpected event that pops out of the blue and has, temporarily, a big impact on the stock market or a sector of the market. Examples include the surge of inflation from 3% to 13% in the 1970s (accompanied by similar increases in interest rates), the spurt of interest rates to an unbelievable 10% in October 1987 (when inflation was only 3.5%), the Iraqi invasion of Kuwait in 1990, the Asian financial collapse in 1996, and the jump in energy prices and the somewhat related California energy crisis in the past 9 months.

By definition, such events are unpredictable, but because we know they will occur occasionally, we should be prepared for them by prudent portfolio construction. We should also recognize that these shocks will not be fatal to the sensible investor; they just have to be waited out.

When one looks at all the factors influencing investment performance, it is clear that a great many are unpredictable. But, in most cases, these relate to the short term, while the forecastable forces are generally long-term in nature. And they have the greatest influence on ultimate investment success. Many investors, especially inexperienced ones, worry a lot about "confusing outlooks" and, therefore, expend far too much energy in fruitless attempts to forecast the unforecastable. Once we can admit what we do not know and understand that uncertainty is part of investing, we can focus our attention on what we do know. This will not always provide the right answer, but it will increase our odds of success, and it will avoid the anxiety that occurs when forecasts of the unforecastable prove wrong.