Forecasts? I Haven’t Got A Clue …

Small Worlds

We predict things all the time, we can't help ourselves. And in the small world that constitutes our immediate bubble of experience those predictions may have some validity. But in the big world that we inhabit they often don't.  Which of those worlds do you think more accurately represents stockmarket investment?

It's difficult for us to accept that our small world experience doesn't scale up to the big world, but it's often true. To all intents and purposes we're infants teetering on the edge of the volcano: to all intents and purposes we know absolutely nothing worth knowing.

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Whither Forecasting? The Butterfly Stirs …

Weathered

Earnings forecasting is a triumph of accountancy over reality: given the complexity of most corporations an accurate forecast of earnings is logically, and numerically impossible.  Yet corporations guide and analysts analyse and, mostly, they all end up looking wise.

It’s all nonsense, of course.  The economy is a complex adaptive system comprised of billions of working parts.  The realistic chance of anybody predicting anything minutely accurate about anything of any interest is approximately zero, to several decimal points.  As any weather forecaster could tell you.

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Forecasting A Financial Earthquake

Guru-nomics

It’s that time of year when every self-respecting student of markets blows the dust off their crystal ball, and sets about attempting to forecast the direction of markets for the next year. Some pore over charts, others examine the history of presidential election years, some analyse market data and others, surprisingly large numbers of others, consult star charts.

Financial forecasters suffer from the same problems as earthquake forecasters – they don’t understand the underlying principles of what they’re trying to analyse. While the latter generally recognise this and have the sense to put in place the appropriate caveats the former mainly seem to be blind to the possibility of error. Of course, the fact that over-confident earthquake analysts may lose their careers and reputations while their equivalent in finance will merely have to wait another year to assay an attempt at guru status may have something to do with this.

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Blood on the Street

“The time to buy is when there’s blood in the streets”, Nathan Rothschild (attributed).

Micro or Macro?

Normally stock picking investors are interested in the microeconomics of firms; their earnings power, competitive advantage and so on. These factors will, over lengthy periods, determine whether companies outperform their peers or not. In recent years, though, a curious thing has happened: these self-same investors have become more concerned with macroeconomics; the trends and decision making processes within the overall economy.

It appears that investors no longer worry much about the fundamentals of investments or even the wiggly predictions of charts, because they have a much more basic way of assessing the likely trajectory of stocks: political analysis. And the result of this may be that we will have blood running in the streets. Again.

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James Randi and the Seer-Sucker Illusion

Illusion is not Forecasting

Every morning before he left home the illusionist James Randi used to take a piece of paper and write on it “I James Randi will die today”. He’d then sign and date it and slip it in the pocket of his jacket. Had he died, of course, the world would still be full of credulous believers insisting that he was a genuine psychic seer. We smart investors laugh at such fools, of course.

We shouldn’t, though, because every day we’re the victims of people just as clever as Randi and without any of his good moral sense. Every day, across the world, people forecast the unforecastable and predict that markets will boom, or bust, or stagger sideways like a drunken sailor. Eventually one of their predictions comes true and gullible people everywhere equate this with foresight when, in fact, the forecaster has simply been slipping a note in their pocket each morning. In a world where everyone predicts everything occasionally someone’s going to be right.

The Cowles Study

The evidence that most forecasters are simply practising the illusionist’s sleight of hand has been mounting for a very long time. Way back in 1933 Alfred Cowles published a paper on Stock Market Forecasting which “disclosed no evidence of skill in forecasting”. When he extended this study in the 1940’s he commented:

“The wording of many of the forecasts is indefinite, and it would frequently be possible for the forecaster after the event to present a plausible argument in favor of an interpretation other than the one made by the reader”.

Gosh, do tell.

Cowles’ research used the forecasts as a basis for actually making investment decisions – so a completely bullish forecast was assumed to cause an investor to invest 100% of their funds in the market. Computing the compounded results of acting on these forecasts led to a series of observations, the gist of which is that the forecasters exhibited no aptitude for forecasting. Indeed, they underperformed the market and were consistently, by a factor of 4 to 1, on the bullish side:

“The persistent and unwarranted record of optimism can possibly be explained on the grounds that readers prefer good news to bad, and that a forecaster who presents a cheerful point of view thereby attracts a following without which he would probably be unable to remain long in the business of forecasting”.

A 50-50 Bet

Given that markets were down around as much as they were up in the period under study and that forecasters were nearly always bullish it’s fairly easy to see that they’d be right about 50% of the time. Which is what Cowles found. In fact if you take a view that most forecasters are always bullish you can take a view that most forecasters will look like geniuses in a bull market and bozos in a bear market without exhibiting any particular skill in either direction. Similarly the smaller number of forecasters who are usually bearish will obtain the reverse position. To whit: forecasters forecast nothing, they’re simply signing their death certificate each morning.

In the current environment, therefore, we might expect to see a few consistently bearish commentators looking as though they can outwit the markets. Nouriel Roubini, aka Dr. Doom, has recently pointed out that his s track record of forecasting major moves in the recent past is very good – having called five out of six movements correctly. Only the five called correctly were all downwards and the other one was the mother of all rebounds.

Roubini is, by far, one of the most intelligent commentators on markets, but the point is that trying to figure out whether any recent record of success is attributable to skill or luck is pretty much impossible. So the question is: if forecasters are so useless why do people keep on using them?

The Seer-Sucker Theory

J. Scott Armstrong has come up with The Seersucker Theory to explain this. What he showed, through a wide range of examples taken from finance, psychology, medicine, etc was that forecasting success is not generally related to expertise over and above a pretty minimal level of competance In fact forecasting accuracy seems to drop once people get above a certain level of expertise. It’s not entirely obvious why this is but there are hints that confirmation bias is involved: seers are less likely to look for disconfirming evidence to cross-check their opinions than less confident semi-experts.

Meanwhile the seer-sucker theory states:

“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of suckers”.

Or: for every seer there’s a sucker. One reason for this might be to do with avoidance of responsibility on behalf of the suckers. All too often in situations involving risk and uncertainty “experts” are called in who have no realistic chance of making a better decision than anyone else: that’s the problem with uncertainty. It’s uncertain. It’s unpredictable.

Herds of Analysts

However, Hong, Kubik and Solomon in Security Analyst’s Career Concerns and Herding of Investment Forecasts have proposed an interesting variation of why analyst forecasts aren’t very good in general. Herding – the behavioural trait that causes investors to move in a given direction at the same time – is triggered by career related incentives. This, of course, is not generally a factor for private investors and therefore is often neglected in considerations about why professionals make their recommendations.

What they find is that younger analysts tend to herd more than their more experienced colleagues: less experienced analysts tend to be punished more heavily for getting their forecasts wrong so they have every incentive to stick with the crowd. In contrast older analysts, who have presumably built up their reputations, face less risk of termination. Basically if a younger analyst makes a bold forecast and gets it wrong they’re likely to lose their job, while doing so and getting it right seems to make little difference to their immediate career prospects.

Although the study implies that the more experienced analysts are more accurate forecasters it, unfortunately, doesn’t make clear whether they do any better than chance over long periods. If Cowles’ findings still stack up the probability is not. Either way relying on consensus forecasts by great stampeding herds of perversely incentivised analysts isn’t likely to yield great results. Look for the outliers and then analyse them: still no free lunches, just hints and intimations.

Give Me Stories, Not Facts

Of course, in writing this, I’m well aware that forecasters will carry on forecasting and followers will carry on following: McKinsey have just published another study confirming nothing’s changed. When the inventors of the crop-circle came forward to explain how they’d fooled scientists the world over with a bit of ply-wood they were almost universally ignored. James Randi has made a second career out of debunking mystical charlatans who prey on people’s gullibility. Yet still they believe and often react violently to having their illusions shattered. It’s as though we can’t grow up and face the real world: it seems that fairies, dragons, magic and mysticism are so much more attractive than the grim reality of credit card repayments.

And this is the hidden truth – we find stories more congenial than facts. Markets are driven less by fundamentals and more by tales of derring-do. Forecasters are story-tellers not diviners of the future. Like all authors of fiction we should enjoy them for what they are: just don’t confuse their narratives with proper investing.



Related articles: Investing With a Time Machine, Investment Forecasts: Known Unknowns, Real Fortune Telling

Anatomy of a Growth Investor

Martinis in the Jacuzzi

The twentieth century gives us many examples of great investors but it’s an interesting fact that these are almost from the value side of the tracks. From Ben Graham to John Templeton and from Bill Ruane to Warren Buffett the men – and they’re all men – who’ve made extraordinary returns were all originally value investors.

With a single exception. Standing alone as a self-confessed, all-in growth style investor is Philip A. Fisher, who initially learned his investing skills during the downturn in the early 1930’s. Reading anything by Fisher is like sitting in a bubbling Jacuzzi sipping on a vodka martini and contemplating an evening of gentle debauchery with the Arts faculty: both a pleasure and an education.

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Money Matters, Your Opinion Doesn’t

Blame the French

Our brave new world is filled with a cacophony of opinions; everyone’s an expert. The proliferation of media channels, accompanied by ever more desperate attempts to keep up with social networking and inclusivity trends, is leading to a world governed by the lowest common denominator. Now get this: I want to be informed by people who actually understand what they’re talking about, even while reserving the right to disagree with them, rather than by someone whose main skill is in double-jointed thumbery and text messaging.

Aliens viewing the output of terrestrial media from afar are probably wondering what type of disease is decimating the intelligence of the average Earthling. This babble of uninformed opinions is swamping the already low level of intelligent comment available and nowhere is the problem greater than in finance where people start with the view that possession of a small amount of capital and an internet connection makes them gifted and talented investors. Still, if nothing else, we can probably blame the French.

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Irrational Numbers: Price Clustering & Stop Losses

Universal Number Theory

One of the odder things about the universe is that the small set of numbers that define its structure, the so-called universal constants, don’t seem to have any structure of their own. You’d have thought that whatever immortal deity breathed life into the whole shebang would have at least have bothered to make sure that reality was defined in simple integer values your average gameshow contestant could remember. Yet someone’s just calculated Pi to more decimal places than you can read in a lifetime. The universe is strangely irrational, it would seem.

More likely, however, is that the irrationality lies in our heads. If you look at the way we treat numbers for investment purposes it’s probably a good job the infinite cosmos is specified in irrational numbers, because if it were otherwise we’d probably have sold it to the lowest bidder eons ago. Humans, it seems, treat numbers as an approximation to reality, unlike reality; which treats humans as an approximation to nothing.

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The Case Against Re-Emerging Markets

Brave Punditry

If you’re of a contrarian viewpoint you might cast your eyes across the pundit’s tips for the best performing sectors of 2010 – or, indeed, any year – with a slightly jaundiced eye. This year’s favourite flavour of investment is emerging markets. There are strong and powerful arguments in support of this particular long-term trend but you’ll rarely find the short-term value counterargument.

Counterarguments are critical for sensible value investors, because they force us to consider what could go wrong despite what our deceitful and biased brains are telling us. Any idiot can see what can go right – and, indeed, they spend a lot of time telling us about it – but putting a purely positive spin on any investing situation doesn’t come close to providing a sensible basis for allocating our valuable and scarce capital.

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Investment Forecasts: Known Unknowns

End of Year Epiphanies

At the end of every calendar year we experience a rush of forecasts on the likely direction of various markets and stocks for the next year. You can find thousands of such forecasts on the internet and you can’t pick up a paper without someone or other opining on the subject. In fact, no matter what your preference, you’ll doubtless find someone out there predicting whatever you want.

The uselessness of these predictions was carefully explained by the Ancient Greek philosopher Socrates, two and half thousand years ago. Not letting death, the lack of Ancient Greek stockmarkets or the fact he lived in an economy based on slavery get in the way of a good analogy, Socrates noted that he, at least, knew what he didn’t know. Which in investment analysis terms is about as close to an epiphany as you’re likely to get.

From Socrates to Rumsfeld

Socrates seems, as far as we can tell, to have spent his life in philosophical musings, preferring to spend his time asking the supposed wise men of Athens for their insights rather than doing anything more economically useful. His conclusion was, largely, that they didn’t know very much – an insight that echoes down the ages. They, on the other hand, decided that they didn’t like a smartass and the result is a lesson to would-be gadflies the world over.

In particular he seems to have annoyed the powerful by informing them that he knew something they didn’t. Having already upset them by showing up exactly how dim they were he then compounded his crimes by revealing his secret: “I know what I do not know”. If this sounds familiar, you’d be right:

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”

It’s long way from Socrates to investment analysis via Donald Rumsfeld but I think we’ve just managed it.

The Known Unknowns of the Market

Socrates’ known unknowns are important for markets, because each of us can know – with something approaching certainty – that one of these is that there are people out there who know more about investing than we do. If different participants have different abilities when it comes to analysing and interpreting information then, by definition, the markets can’t be strongly efficient. Even if we’re all rational we aren’t all equally gifted.

However, if we are all rational then, if we recognise that other people know more than we do, we ought to stop investing actively. After all, if investment analysts and institutions have this much of an edge on us it makes no sense for anyone without demonstrably superior investing skills to try and compete with them. So if we’re rational maximisers then we ought to buy index trackers and content ourselves with sitting on the sidelines watching the heavyweights slugging it out.

Extending this argument, as the least good investors stop competing, the remaining participants will themselves divide into the best and worst groups with the winners taking the spoils. Once again members of the worst group should, rationally, stop investing actively and this process of winnowing should carry on until there is only one investor left. Who then has no one to invest with, leading to the heat death of efficient markets.

The Unknown Unknowns of the Market

Now, obviously, this isn’t what’s happening. Millions of people continue to dabble in active stockmarket investment in spite of having no obvious ability to outperform markets. Even better, they carry on investing even when they’re losing money, failing to learn from their mistakes. These people, who clearly don’t know what they don’t know, are the inefficient grit in the gears of the efficient market. Bless them, because without them value investing couldn’t work.

The behavioural weaknesses of market participants – certainly their overconfidence and lack of insight into the reasons for past underperformance – are clear and powerful drivers of market inefficiencies. Exploiting these inefficiencies should be the goal of all right thinking investors, which means that we need to be constantly looking for where people are behaving most irrationally.

These manifest inefficiencies mean that making anything approaching a detailed forecast is almost impossible. The end-of-year forecasting bonanza, which is largely driven by the need to fill column inches, is one of the odder and more pointless activities humans engage in, somewhere up there with bog-snorkelling and cheese rolling.

Random Forecasts

There’s so much data out there it’s possible to find evidence to support any theory you might like. Someone, somewhere, will be right – which is nice for them, but not much use for the rest of us trying to avoid losing money. Of course, the people who ought to be best at predicting the motion of the stockmarket ocean are those that are paid for the experience: security analysts.

Going all the way back to the original work of Alfred Cowles’ Can Stock Market Forecasters Forecast? in 1932 the evidence for analysts outperforming the market is ambiguous, to say the least. Possibly the best gloss on the situation comes from this paper by Ericsson, Anderson and Cokely who identify that the best analysts do seem to have an edge in making predictions but that seems to be linked to extremely constrained areas of expertise, is not generalisable to wider markets and is too small to be exploitable when costs are taken into account:

“With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance”.

So as it stands even the best brains in the business don’t have the ability to outperform the markets so, naturally, the rest of the world – which has next to no experience of market behaviour – expects to outperform the analysts, heaven help us. The only thing that the mass of return seeking mavens has to offer as an advantage over the analysts, who, as we discussed in Rise of the Machines, have the most powerful computer systems, the best researchers and the cleverest algorithms around, is their willingness to outwait the latest trend. Obviously this is, generally, the only attribute they’re not willing to use to their advantage.

Hemlock for the Pundits

The end-of-year forecast frenzy is simply a bit of temporally induced fun which shouldn’t be taken seriously. Recognising not just that we don’t know very much but that most of the people telling us what to do don’t know very much either is an important step towards freeing ourselves from the straitjacket of our social conformity and becoming intelligent investors.

Socrates, of course, ended up drinking hemlock and committing suicide after annoying too many powerful people. That seems like a step too far in search of a perfect investing strategy but being willing to go against the trends and to ignore opinion is absolutely critical. So if you must read the pundits’ predictions at least do so usefully: write them down and then compare them with what actually happens.


Related Articles: Contrarianism, Regression To The Mean: Of Nazis and Investment Analysts, Technical Analysis, Killed By Popularity

Real Fortune Telling: Dividend Forecast Indexing

Fallible Analysts, Reliable Dividends

Unfortunately investment analysts are just as prone to the standard behavioural biases as the rest of us and are inevitably more affected by incentives designed to promote short-term outperformance. In particular when market conditions become turbulent most earnings forecasts become slightly less useful than an unsinkable submarine.

Dividends, on the other hand, are less volatile than earnings. Even better, analysts' dividend forecasts are much more reliable than their earnings forecasts. So if dividends are a sign of healthy companies then using analyst dividend forecasts as a forward signalling mechanism may offer a way of obtaining market beating returns at little excess risk. Although, as it turns out, whether this works or not depends on whether your country’s legal system was created by a bunch of Vikings masquerading as French nobles rather than the descendents of Julius Caesar.

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