Letters of the Week, Special Edition

At risk of being shot dead, Scott Francis rises to a subscriber’s challenge and makes a market forecast.

In our letters section last week subscriber David King entertained us with a jovial, if hair-raising, request to step up and predict where the ASX, currently at around 4240, might finish the calendar year. Scott Francis, our long-time Queensland-based correspondent, has mounted the podium and today’s letter’s section is wholly dedicated to the task. We hope you enjoy our edited version of the correspondence between Scott and David.

Original letter from David King

In my dream last night an armed band of enraged investors, friends of mine but totally unhinged by horrid recent losses, kidnapped at gunpoint all Eureka Report's contributors and offered the following deal: Be shot dead now, or estimate the level of the All Ords at December 31, 2012, and be shot dead then if not within 20% of the truth.

Response from Scott Francis

Aside from a little nervousness at all the talk of shooting, David’s challenge was one I was happy to buy into. The two challenges: guess the All Ords at the end of 2012, and find a way to get a 10% return on an equity investment.

Before pinning the ears back with bravado and making a prediction about what the future holds, it is important as investors to acknowledge the uncertainty of the future – and therefore any forecast.

The last time I stuck my neck out with any forecasting was at the end of the dreadful year of 2008. At the time sharemarkets were around the 3600 level. My forecast was for the ASX 200 to finish the following year at 4800 points – and it finished at 4722. This is a pretty solid result, within 2% of the final figure. Skill? To be honest no, just luck.

This is a problem for investors: we tend to think that someone who has made a correct forecast has some sort of skill. In reality, it may well just be luck. There are thousands and thousands of people making forecasts; by sheer luck alone some will be correct a number of times in a row. The trick for investors is not to have too much money exposed to their forecasts when their luck runs out.

Which brings us back to David’s challenge: where will the market end in 2012? The market is now on a price/earnings multiple of 12. The inverse of this (1/12) gives us an earnings yield of 8%. That is, every $100 invested the average portfolio of companies will earn $8. Let us assume that companies are able to grow their earnings in line with inflation, about 3% (a modest estimate, but who knows what economic shocks companies might have to face). So, they will earn $8 this year for every $100 invested, and be on track to increase those earnings to $8.24 next year. Let us also assume that of the $8 they earn, they invest $4 back into the company with the other $4 being paid as a dividend. Another assumption is that the $4 invested back into the company will generate a return of 10%, so earnings will increase to $8.64.

If the market continues to price earnings on a multiple of 12, then this $8.64 should have increased in value by 3.68% to $103.68. Here comes the biggest punt of them all: I am going to look forward to December 2012 and say that the current market concerns (Europe) will have abated a little – based as much as anything on the tendencies that markets have to overreact to things. On that basis I am going to say that shares will have recovered to be priced on a P/E multiple of 13.5 – meaning our $100 initial investment will now be valued at $116.64 – or that shares will increase in value by 16.64% over the year.

That will take the All Ords to a level of 4900. David has provided a pretty generous 20% window (albeit with a far less generous punishment of shooting), and I am happy to stick my neck out with a forecast (read guess) of 4900 points.

Given my view of the overall market, I would be comfortable that a simple ETF (Exchange Traded Fund) that gave exposure to the dividends and capital growth of the sharemarket might be the best approach. This gets rid of the volatility that comes with individual shares, and will capture the whole of market return with little cost.

To read this week's letters, click here.

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