Would you let a mystic manage your investment portfolio?
Washington Post, November 28, 2015
“Forecasting security prices is not properly a part of security analysis.” –Benjamin Graham, economist and professional investor
It’s that time of year again when the mystics peer deep into their tea leaves, entrails and crystal balls to divine what’s ahead.
Which means it’s also time for my annual reminder: These folks cannot tell the future. Ignore them.
Most forecasters are barely familiar with what happened in the past. Based on what they say and write, it is apparent they often do not understand what is occurring here and now. Why would anyone imagine that they have the slightest clue about the future?
This is not my opinion, but a simple statistical fact: The data overwhelmingly show that the skill set of the predictive pundits is no better than a coin toss. The odd person gets these forecasts about the economy and stock markets right each year, but the lack of any sort of consistent winners and losers means that, mathematically, it is a random outcome.
I have kvetched about predictions and forecasts for more than a decade (see this, this, this, this, this, this, this, this, this and this). But don’t take my word for it. Let’s consult some of the smartest strategists and market observers I know. (Confirmation bias alert: Not surprisingly, they all agree with me).
James O’Shaughnessy is the author of the classic “What Works on Wall Street,” and runs O’Shaughnessy Asset Management, managing about $5.6 billion. “Forecasts are useless,” he says. If we were to look at any major historical market move, we would be hard-pressed to find a credible source predicting major events. O’Shaughnessy notes that prior to the 1987, 2000 and 2008 crashes, “most forecasts were rosy, saying everything is fine.”
Every major academic study proves that “we stink at making predictions about the future,” he says. “What we should be doing is ignoring every single forecast and relying on the historical probability of how markets perform over the long term.”
Morgan Housel, a columnist for the Motley Fool and all-around sharp observer, took O’Shaughnessy’s observations a step further: He looked at the average Standard & Poor’s 500-stock index forecast made by the 22 chief market strategists of the biggest banks and brokerage firms from 2000 to 2014.
On average, these annual forecasts missed the actual market performance by an incredible 14.6 percentage points per year (not 14.6 percent, but 14.6 percentage points!) It is also noteworthy, Housel added, that “from 2000 to 2014, the 22 strategists on average did not forecast a single down year, ever.” During that period, the Nasdaq crashed 78 percent and the Great Recession sent the major averages down 57 percent. The strategists failed to anticipate any of it.
“Professional market forecasters are often called dart-throwing chimps,” Housel said. “It turns out this might be an insult to chimps.”
Michael Johnston is senior analyst and chief operating officer at Poseidon Financial. He has called out some of the worst chimps in the forecasting industry, naming names in such classic columns as “A Visual History of Market Crash Predictions” and “The Not-So-Surprising Truth About Gold Bugs.”
As he notes, “a thoughtful and nuanced discussion of future possibilities doesn’t accomplish those goals, but an over-simplified, bold and aggressively marketed prediction does. Volume and creativity trump accuracy.”
Why do they do it? I reminded readers earlier this year of the simple truism that all forecasting is marketing. Once you acknowledge that, it becomes easy to ignore the forecasters.
Laszlo Birinyi is a researcher and market historian. He tracks the forecasts of many strategists and economists. Whether you look at the forecasters as a group or on an individual basis, they are impressively bad. Some of the more outrageously terrible calls Birinyi has tracked include:
• In October 1987, three top technicians (Ralph Acampora, Justin Mamis and Stan Weinstein) size up the markets in Barron’s, noting: “the bull market is fine” – one week before the Black Monday crash;
• Dow 5,000, predicted in July 2010 by Robert Prechter;
• S&P500 to break 666, stated in May 2012 by Societe Generale’s Albert Edwards;
• On Dec. 31, 2012, 12 Wall Street sell-side firms forecast, on average, gains of 5.3 percent for the S&P500 in the coming year. The actual 2013 performance was up more than 30 percent (with dividends);
• Oct. 15, 2013, technical analyst Tom Demark noted, “Dow Jones Index pattern reflect warning of parallels to 1929 stock market crash.” (More than 2 years later, still no crash.)
• Mark Faber has forecast a “1987-like crash” every year since 2012.
• Valeant Pharmaceuticals (VRX) had 15 buys, seven holds and only one sell the day before it collapsed in October; after notching big gains, its shares are now down more than 50 percent year to date.
As we noted earlier, these are some of the smartest, most respected analysts around. But according to Professor Richard Thaler, who teaches at the Booth School of Business at the University of Chicago, they all suffer the same issue. As he puts it: “Decision-makers have been betrayed by a flaw that has been documented in hundreds of studies: overconfidence.”
Thaler is the author of “Misbehaving: The Making of Behavioral Economics,” and is widely known as the father of Behavioral Economics. This is an area of investor behavior with which he is very familiar.
David Rosenberg, the chief economist and strategist at Gluskin Sheff, points out another aspect of the over-optimism problem: the right-or-wrong, all-or-nothing approach of forecasters. It is useless to investors. More important than any forecast are some key questions: “What is the conviction level over your base case, and if you are wrong, in what direction?” And even more crucially, if your base case is incorrect, then: “What happens to scenarios B, C and D?”
Perhaps the pithiest advice on the subject was offered by management expert Peter Drucker: “I have been saying for many years that we are using the word ‘guru’ only because ‘charlatan’ is too long to fit into a headline.”
Truer words have never been spoken.