Justin Lahart has an excellent column in today’s WSJ on a subject near and dear to our hearts: Misusing the stock market as a forecastging mechanism:
"Investors who trusted in the magical powers of the stock market to forecast a recovery in housing have been finding out what can come of trusting in fairy tales.
Less than two months ago, the idea that the housing market was at a turning point, and that shares of home builders were a screaming buy, was firmly established. In early February, the Dow Jones Wilshire U.S. Home Construction Index of home-builder stocks was 39% above its July 2006 low point. Since then, it has tumbled 21%."
We discussed this very same subject last week: EMH (Part 3): The Home Builders:
"What’s been even worse, we continue to see people reaching all
manners of ill-advised conclusions from the shorter duration charts of
various flavors and sectors; these have the unfortunate tendency to
lead the faithful astray. In the past, we have advised to "Beware Economists seeking guidance from stock markets;" the very same meme applies to traders and strategists drawing bold conclusions from very short term charts also.
Which leads us to some recent charts. Let’s take a look at the Home
Builders: Its amazing that some people claim to read charts, yet
manage to draw the precisely wrong conclusions from them. Remember,
since no one knows the future, all investing and trading are games of
probabilities regarding any given possible outcome. We cannot expect
perfection — but we can at least hope to see some measure of
intellectually defendable theories. All too often, even that modest
goal is missed.
A classic example of this misunderstanding has been the action in
the Homebuilders over the past few years . . ."
In Lahart’s column, he looks askance at the circular nature of a certain type of equity market analysis:
"How did investors come to believe housing was getting better in the first place? One possibility is that the rebound in home-builder stocks tempted them into seeing signs of improvement that weren’t really there. While there is a certain allure to the idea that stocks, which move on the real-money decisions of thousands of investors, are better at predicting the future than any forecaster, this sort of thinking can be dangerously circular: Home-builder stocks are going up, therefore housing is getting better and therefore it is time to buy home-builder stocks."
In other words, you should not believe that sector momentum is necessarily telling you anything other than the fact that there is momentum in a that sector.
The same can be said about markets in general. In the past, we have also taken economists to task for this bugaboo (Beware Economists seeking guidance from stock markets). We have also been critical of the blind faith some place in prediction markets for the very same reason.
This isn’t to say that the market’s ability to discount various outcomes isn’t a valid tool; The inverted yield curve, major trend breaks, market sector leadership all provide clues as to the probabilities of likely future outcomes. Indeed, there are dozens of internal data points which provide various measures of clarity as to future probabilities.
But blind reliance on the markets as a magical forecastor of the future? Thats placing religon over science. Its track record is only as good as the collective reasoning of the crowd, as logical as a pack of hormonal teenagers, as wise as a mob of soccer holligans.
Markets are only marginally better than its components: skittish, irrational,dangerous-in-crowds, susceptible to emotions human beings. While they may remove some of the noise, they also manage to provide evidence of the precisely wrong conclusion at exacvtly the worst possible time.
Some will incorrectly take this criticism of markets forecasting accuracy as proof that your humble author believes he is smarter than the market. Indeed, the last time out we criticized this school of thought, we were taken to task by for our "arrogance and hubris" for believing markets occasionally get things wrong. It is worth noting that those critics were long the homebuilders, and have since been carried out on their shields.
Mr. Market is at times a Rorschach test, a blank slate upon which participants project their hopes and fears. He reveals the personality characteristics and emotional functioning of investors by their interpretations of the noise he generates. Remember this the next time you are tempted to create a grand theory of what happens next based only upon a few of his recent squiggles . . .
EMH (Part 3): The Home Builders
Tuesday, March 13, 2007 | 06:16 AM
Believing In House of Cards Haunts Investors
WSJ, March 19, 2007; Page C1