Perhaps the problem starts with the idea that intelligence is related to the ability to correctly and consistently predict the movements of markets and individual securities.

A number of factors explain why this is so much harder than many people assume.

The first is that a forecast for, say, an individual stock usually depends on a multitude of other assumptions. If just one of those assumptions proves incorrect, the whole edifice comes crashing down. Some examples:

In July 2010, a major brokerage in Australia placed a 'buy' rating on the steel producer Bluescope Steel, saying the company was cheap relative to its peer group and stood to benefit from a recovery in the Australian housing market.¹

Unfortunately, Bluescope got much cheaper. In fact, it was the worst performing stock on the Australian market over the subsequent year. From July 2010 to the end of April 2012, Bluescope delivered a negative total return of just under 80 percent, compared with the broad market's 6 percent gain over the same period.

The company was hit by a combination of forces over this period, including falling domestic steel prices, a surging Australian dollar that made it uncompetitive with cheaper imports and a slowdown in the home building market.

Clearly, the brokers who tipped the stock as a buy incorrectly assumed housing was on an upswing. Their assumptions about the currency and conditions in global steel markets may also have been awry. Many things can bring a forecast undone.

Another wildcard is technology and consumer preferences. In June 2009, a brokerage² raised its price target on Research in Motion, maker of the Blackberry mobile device, citing increased shipments in the smartphone market and stable margins.

"Our extensive retail checks suggest the unit trajectory for RIM will likely exceed Street estimates," the analyst said in a note to clients. Rating the stock as a "conviction buy", he raised his six–month price target to $C96 from $C85.

That was a shame, because from that moment on, it was virtually all downhill for RIM and by May 2012, its shares were trading at a little under $C12.

What the market didn't see was the phenomenal take–up of the Apple iPhone and devices running Google's Android operating system. For whatever reason, consumers decided the Blackberry phone was clunky and uninteresting in comparison.

Alongside incorrect assumptions, changes in technology and shifting consumer preferences, forecasts often can fall down because of external events totally unrelated to the company under consideration.

In February 2011, a major Japanese brokerage³ raised its rating on nuclear power station operator Tokyo Electric Power ('Tepco') to 'outperform' from 'neutral', while lifting its price target for the stock to Y2,450 from Y2,050.

Just weeks after that forecast, a devastating earthquake and tidal wave crippled the company's Fukushima Dai–Ichi nuclear power station, left thousands dead and forced 160,000 people from their homes.

Of course, nothing can compare to the human losses of that disaster. But over the 16–month period to the end of April this year, Tepco was the worst performing stock on the Japanese equity market, falling nearly 90 percent in value.

By March this year, Tepco was facing billions in compensation claims and was pleading for $US12 billion in public funds to avert an outright collapse.

Who could have predicted the scale of that disaster? And who knew that Tepco would be so poorly prepared?

So you can see forecasting in financial markets is hard. It is hard because any one of the many assumptions underpinning your outlook can come undone. It is hard because technology and consumer preferences can change in unpredictable ways.

But, most of all, it is hard because correctly forecasting markets requires an ability to predict news before it happens. It doesn't matter how smart an analyst might be. It doesn't matter how careful they are in their assumptions. Things can still happen out of left field that can wreck their careful analysis.

The possibility of industry–specific or stock–specific factors damaging our investments is the reason we should diversify – across stocks, across asset classes, across industries and across countries. We need to lessen the impact of the unexpected.

It all recalls a telling quote from the 1950s from the then British Prime Minister Harold Macmillan. A journalist asked the politician what could cause his government to run off course. Macmillan's reply was typically dry and succinct:

"Events, dear boy, events."

1. Broker Tips, Australian Financial Review, July 7, 2010

2. Goldman Sachs Raises Price Target for RIM, Reuters, June 1, 2009

3. MUFJ MS Raises Tepco to Outperform, Dow Jones Newswires, Feb 9, 2011

But the tone of the article sounded remarkably familiar. We dug out our copy of the "Death of Equities" article appearing in BusinessWeek on August 13, 1979, to have a fresh look. Similar? You be the judge:

BusinessWeek, 1979: 
"This 'death of equity' can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than ten years through market rallies, business cycles, recession, recoveries, and booms." 
Financial Times, 2012: 
"Stocks have not been so far out of favor for half a century. Many declare the 'cult of the equity' dead."

BusinessWeek, 1979: 
"Individuals who are not gobbling up hard assets are flocking to money market funds to nail down high rates, or into municipal bonds to escape heavy taxes on inflated incomes." 
Financial Times, 2012: 
"The pressure to cut equity exposure is being felt across the savings industry. … In the US, inflows to bond funds have exceeded equity inflows every year since 2007, with outright net redemptions from equity funds in each of the past five years."

BusinessWeek, 1979: 
"Few corporations can find buyers for their stocks, forcing them to add debt to a point where balance sheets seem permanently out of whack." 
Financial Times, 2012: 
"With equity financing expensive, many companies are opting to raise debt instead, or to retire equity."

BusinessWeek, 1979: 
"We have entered a new financial age. The old rules no longer apply." —Quotation attributed to Alan B. Coleman, dean of business school, Southern Methodist University 
Financial Times, 2012: 
"The rules of the game have changed." —Quotation attributed to Andreas Utermann, Allianz Insurance

BusinessWeek, 1979: 
"Today, the old attitude of buying solid stocks as a cornerstone for one's life savings and retirement has simply disappeared." 
Financial Times, 2012: 
"Few people doubt, however, that the old cult of the equity—which steered long-term savers into loading their portfolios with shares—has died."

When the first "Death of Equities" article appeared, the S&P 500 had underperformed one-month Treasury bills on a total return basis for the fourteen-year period ending July 31, 1979 (107.0% vs. 119.6%, respectively). Was buying stocks in August 1979 a smart contrarian strategy? Yes, but only if one had the patience to stick it out for years. Imagine the frustration of an investor who had been counseled to "stay the course" in response to the "Death of Equities" article appearing in August 1979. Stocks did well for a while, jumping over 27% from August 13, 1979, to March 25, 1981, when the S&P 500 hit an all-time high of 137.11. But by July 31, 1982, stocks had given back all their gains, and the S&P 500 was almost exactly where it had been nearly three years earlier. As of July 31, the S&P 500 had extended its underperformance relative to one-month Treasury bills to seventeen years (total return of 150.5% vs. 213.6%).

Imagine this same investor arriving at her financial advisor's office on Friday, August 13, 1982, with a three-year-old copy of BusinessWeek under her arm. Stocks had drifted lower in the preceding weeks, and the S&P 500 had closed the previous day at 102.42. "You told me three years ago to stay the course, and I did," she might have remarked to her advisor. "It hasn't worked. Obviously, the world has changed, and it's time I changed too. Enough is enough."

We suspect even the most capable advisor would have faced a big challenge in seeking to persuade this investor to maintain a significant equity allocation. For many investors, seventeen years is not the long term, it's an eternity.

Superstitions aside, stocks rose that day, with the S&P 500 advancing 1.4%. It wasn't obvious at the time, but August 13, 1982, marked the first day of what would turn out to be one of the longest and strongest bull markets in US history. The S&P 500 was 16% higher by the end of the month and went on to quadruple over the subsequent decade. The table below shows data for the S&P 500 on a price-only basis. With dividends reinvested, the return would be materially enhanced.

One of the authors of the FT article, John Authers, is familiar with the BusinessWeek article and wary of making pronouncements that might look equally foolish ten or twenty years hence. In a follow-up article appearing several days after the first, he appealed for divine assistance in his forecasting effort: "O Lord, save me from becoming a contrarian indicator." Nevertheless, after revisiting his arguments he remained persuaded that the climate for equities was too hostile to be appealing.

We should not use this discussion to make an argument that stocks are sure to provide investors with appealing returns if they just wait long enough. If stocks are genuinely risky (which certainly seems to be the case) there is no time period—even measured in decades—over which we can be assured of receiving a positive result. Nor should we seize on every pundit's forecast as a reliable contrarian indicator. With dozens of self-appointed experts making predictions, some of them are going to be right. Perhaps even John Authers.

The notion that risk and return are related is so simple and so widely acknowledged that it hardly seems worth arguing about. But these articles (and others of their ilk) offer compelling evidence that applying this principle year-in and year-out is a challenge that few investors can meet, and explains why so many fail to achieve all the returns that markets have to offer.

References

"The Death of Equities," BusinessWeek, August 13, 1979.

John Authers and Kate Burgess, "Out of Stock," Financial Times, May 24, 2012.

John Authers, "The Cult of Equities Is Dead. Long Live Equities," Financial Times, May 27, 2012.

S&P data are provided by Standard & Poor's Index Services Group.

Stocks, Bonds, Bills, and Inflation Yearbook. Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).

'And you thought 2011 was tough?' So went the headlines in December as media and market pundits, reflecting on a miserable year, saw no respite for investors in 2012. But markets have a funny way of confounding expectations.

To be sure, the reasons to be anxious were piling high as the year turned, with European politicians dithering over how to tackle a tottering mountain of sovereign debt, policymakers in the US running short of options and emerging markets not providing the cushion that many investors had hoped for.

The general view, as expressed through the media, was that there would be more muddling through in early 2012. "Buckle up!" warned the respected Barron's magazine. "For investors frightened by the stock market's volatility in the past six months and tired of worrying about places in Europe once given little thought, 2012 promises scant comfort — at least in the first half."

As an investor, if you had taken that advice you might be ruing it now, as global equity markets — as measured by the MSCI World index — have registered their best start to a calendar year in 21 years. The index was up by just over 10% in US dollar terms as of the end of February. You have to go all the way back to 1991 to find a better start.

Added to that is that much of the leadership for the turnaround is coming from the US, an economy that many observers just two years ago were writing off in favour of the emerging powerhouse economies in Asia. The US benchmark S&P–500 was up by 9.0% to the end of February. This is also its best start since 1991 and returns the index to the levels of June, 2008, before the Lehman collapse.

The US market's strong start followed a standout 2011, in which it was one of the best performing markets in the world. And that included most of the emerging markets.

Even Europe, the epicentre of concerns for much of the past year, has exploded out of the blocks in 2012. The Euro Stoxx 50 was up by nearly 12% over the first two months of the year, with the German market rising by close to 20% in US dollar terms.

The renewed buoyancy extended to Asia, where the MSCI Asia Pacific Index has registered 10 consecutive weeks of gains, its longest uninterrupted winning streak since 1988, and powered by strength in energy stocks. Australian stocks have firmed as well, to be up 12.5% year to date in US dollar terms — although in local currency terms, the gain has been less stellar at just over 7%.

Why the change in mood? There are several catalysts for the turnaround in markets so far in 2012.

First, by the end of last year, market participants were discounting a lot of bad news, including a couple of catastrophic scenarios. Fears of mass defaults in Europe and a possible break–up of the euro were seen as entirely possible.

While Europe can hardly be described as being out of the woods yet, the agreement by creditors on a new round of official funding for Greece has eased nerves, as has the European Central Bank's provision of another half a trillion euros in cheap funding to financial institutions.

Second, there have been signs of a turnaround in the US economy, at least compared to the view the market was taking a few months ago. At that time, another recession was seen as on the cards. Since then, official data have shown an improvement in the labour market, a rise in manufacturing orders and a climb in consumer confidence.

Third, central banks are pumping out massive amounts of cheap cash — essentially printing money — to provide liquidity to the financial system and to support the recovery. As well as the ECB's latest cash injection, Japan and Britain have recently extended their so–called "quantitative easing" programs, while China has the cut the reserve requirements for its banks.

Of course, just as it was wrong to extrapolate the pessimism of last year through into 2012, it would be foolish to forecast that the rest of this year will resemble the first two months in tone. No–one knows how markets will perform going forward, because that requires an ability to forecast news. You can always guess, of course, but we tend to think that's not a sustainable investment strategy.

The point of this is to highlight the virtues of discipline and the tendency of markets to absorb news very, very quickly and to look forward to the next thing. Unless you know what the next thing will be, you are wise to stay in your seat.

1. ‘Buckle Up!’, Barron's, Dec 19, 2011