Every time we begin a new year the air seems filled with hope that things will be better in the coming months. Market pundits and observers love to make fearless forecasts, and Paul Merriman, founder of Merriman Berkman Next, is no exception. In this article, Paul looks into the past in order to get a glimpse of the future.

I’ve been thinking about the lessons investors should have learned from 2007. One of them is something I learned a long time ago: Making predictions is a murky, dangerous business.

Imagine you are driving down a freeway in a very thick fog, at night, and you can barely see the lane stripes that are just 10 feet in front of your vehicle.

Do you assume that the freeway ahead of you is clear and therefore continue driving at about your normal speed? Or do you follow the old rule that you should be able to stop within the distance you can see ahead of you, so you slow way down? Either way, you’re asking for big trouble.

If you assume all is well, you could easily crash into something you can’t see in time to stop. If you slow way down, somebody who’s driving a normal speed will probably rear-end you.This is how I feel when I try to predict an upcoming year in the stock market.

Last January, a number of analysts and gurus expressed themselves as “mildly optimistic” about 2007 as the stock market continued to rebound from lows in July 2006. “Mildly optimistic” is not exactly a fearless prediction, and those analysts can’t be held accountable for it because it cannot be measured.

This month, you’ll have the opportunity to read a lot of articles along similar lines. The articles won’t all paint the same picture of the coming year. But each one will be written by somebody who wants to look smart while being in the middle of an environment similar to that highway I just described.

One thing I’ve learned is that no matter how smart you are, you can’t see very far into the dense fog of the future, especially the future of the economy and the stock market. The best you can do is make some guesses and estimates based on what little you do know.

I’m reminded of a comment attributed to Peter Lynch, once the star manager of Fidelity’s former flagship, the Magellan Fund: “If you spend 15 minutes a year studying the economy, that’s 10 minutes too many.”  

I think that’s right. For most people, trying to figure out the U.S. economy is not the best use of their time. If you’re an economist, or if you’re studying economics, of course it makes sense. But if you’re an investor, there’s no payoff that I have ever been able to identify.

So what, you might wonder, am I doing writing this article if I believe it’s a waste of time? Here’s my answer: Thinking about the future isn’t a waste of time if you go about it the right way. Often, that means looking back more than trying to look ahead.

Most of this article is devoted to looking back, seeking lessons from 2007, throwing in a little advice as we go. I’ll end with a prediction for 2008 which will be most meaningful if you read the rest of the article first.  

I like to look at the past to tell me about probabilities. I know the long-term trend of the market is up. What interests me more are the inevitable declines that can shrink my portfolio. The Dow Jones Industrial Average, representing only 30 stocks, isn’t a very great proxy for the stock market; but it’s widely followed, and its history is thoroughly documented. The following statistics relate to this index.

Since 1900, declines in the Dow of 5 percent or so have been frequent; on average they occur about three times a year and last about six weeks – the time it takes to recover the lost value. Equity investors who can’t accept these short-term fluctuations will have a very hard time being successful in the long run.

We call a 10 percent decline a correction. These happen about once a year on average and last an average of 114 days – a bit less than one-third of a year. A severe decline of 15 percent has occurred on average about once every two years; these lasted on average 216 days – about seven months.

A bear-market decline of 20 percent has occurred on average every three and a half years, lasting an average of 332 days, about 11 months. Some bear markets of course are much more severe – and last much longer – than others.
Think about that for a moment. It means it’s normal to be involved in a decline and recovery about one-third of the time, year-in and year-out.

What does this tell me about the future? It tells me I should not be shocked in 2008 if the market goes down by 10 to 15 percent. It also tells me I need to have some patience while I wait for a recovery.

Now let’s see what we can learn from recent history.

One year ago, many people (and I was among them) believed growth stocks would retake the lead from value stocks, which had led for seven consecutive years. This happened, as predicted.

If you had known this in advance, you could have cashed in on your “knowledge” by ditching your value funds and investing instead in the Standard & Poor's 500 Index. That index is heavily weighted with steadily growing, recession-resistant businesses that are widely regarded as safe and comfortable. Had you done that, you could have won the battle while losing the war, so to speak.

In 2007, big growth stocks outperformed value stocks, but only modestly. It seems that much of the growth-is-back money was poured into faster-growing companies, particularly technology companies, driving them up to lofty multiples.

The lesson from 2007: Even if you “know” the big picture of what’s going to happen in the future, without the details you can miss out. My prediction for 2008: Some of the predictions you’ll read will turn out to be right in the broad sense but will miss the details you need in order to take advantage of those predictions. My advice: Diversify wisely, and don’t assume that you know more than the investors you’re competing against.  

Another trend from 2007 was the continued strength of international stock funds, especially emerging markets funds, the largest of which gained 29 to 40 percent in the first 51 weeks of the year, after 20-percent-plus gains in each of the prior four years. A year ago, lots of experts figured this segment of the market was due for a major correction. The lesson from 2007: The experts can be right on the main theme (a correction is in the future) but wrong about the timing. My advice: Diversify widely, and don’t assume that the experts know exactly when certain fairly predictable things will happen.

A third lesson from 2007 is that winning streaks do not go on forever. Real estate investment trusts (REITs) took off in 2000 with gains of 31 percent (while the S&P 500 Index dropped 9.1 percent) to start seven consecutive positive-return calendar years with average annual gains of more than 23 percent.

But REITs hit the skids in 2007, with some of the largest funds in the sector down 16 to 21 percent in the first 51 weeks of 2007. My advice: Think like a long-term investor, and realize that down years are normal in REITs as in all other asset classes. (For more on that topic, see our recent article “Why we still like real estate.” )

   
As we look back at 2007, some investors are feeling pretty smart because of what they did (those who loaded up on energy stocks, for example) and others may feel like dopes (those who concentrated on financial stocks that were clobbered by the subprime lending mess). In each case, the feelings are probably unwarranted. Some people saw a great future in energy stocks and others saw it in financial stocks. One group won and the other lost. It looks a lot like luck to me.

This leads to my real bottom-line advice: Diversify widely, and let the ups and downs of various sectors offset each other. Keep your costs down by investing in index funds. Keep your blood pressure down by leaving the economy to the economists.

Since I have promised a prediction, here goes: In 2008, the great majority of investors who follow that advice will wind up with more resources than those who ignore it. And they’ll have more peace of mind as they drive down the murky, foggy highway into the future.