Operating Earnings Extrapolation & The Butterfly Effect

There is nothing like the emotional roller coaster that comes with managing an investment portfolio. Most of you don’t know me in this capacity but rather as an allocator of funds. To get my head back into the markets as an investor I decided last month to manage a hypothetical portfolio, in full view of all on the internet. I have done this for 2 reasons:

  1. I think I am a really good manager 😉
  2. The personal growth that comes from struggling ones own personal biases, is unmatched by almost all other professions in my opinion and will provide readers of this blog an insight into the “hero’s journey.”

So without further a due visit this link at any time to view my performance and follow the blog, my goal is to outperform the S&P 500 on a risk adjusted basis over the long term.

2015-01-13_1655

Let us start this analysis by looking at a few valuation metrics at the market peaks and valleys. The key focus point here is that the chart presents P/E on an estimated 1yr forward operated earnings basis. As an aside most people simply rely on 1 year historic earnings. Readers of this blog and people who have read my commentaries for a number of years, will know I favour the Shiller/ CAPE 10 yr methodology. The current Shiller P/E ratio is 19.67 versus a 100 year mean of 15.53

S&P bubble Q4 2014

Let us look at how well people forecast 1yr forward operating earnings. The average forecast error is -2% with a large -17.9% std deviation. You can see that people don’t forecast trend changes too well.

SP500-earnings-forecast-backtest2

According to the S&P website the forecast operating earnings for 31 Dec 2015 is $131.01 which is a 14% increase on the preliminary 09/30/2014 actual of $114.51.

In 1890 Henri Poincare developed his three body problem the precursor to Edward Lorenz 1961 discovery of the butterfly effect which forms the basis of chaos theory. As per Wikipedia’s definition, “the butterfly effect is the sensitive dependence on initial conditions in which a small change in one state of a deterministic nonlinear system can result in large differences in a later state.”

So what does all this mean, what is my point? It is actually quite simple. I am trying to illustrate that people capitalizing a naive 1 yr forward earnings into perpetuity which has a notorious empirical history of being highly variable, is likely to have a devastating butterfly effect.

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