A favorite pastime of market pundits is making sport of those
who do forecasting, especially if models are involved. I am
continually amazed at the delight people take in criticizing things
where they have no information. My ongoing mission is to discover
and exploit such errors.
Let us suppose that we have a city in an earthquake zone. There
is a fault line. Our job is to predict something mundane, like
revenue over a toll bridge. We may use various factors to predict
traffic and revenue as the basis for the forecast. Meanwhile, we
all know that there is earthquake potential. If and when the
earthquake comes, the revenue forecast will be seriously wrong.
So we could make a prediction: There will be an earthquake in
the next ten years.
Or we can make a forecast: Here is the expected bridge traffic
Please note that the forecaster is usually correct by ignoring
the earthquake. If he decides to include it, he can be wrong in one
of two ways:
- He can deduct something from each year's forecast, making
them all incorrect by 10% or so; or
- He can guess the year of the quake. He will be correct one
year in ten and wrong in the other years.
Let me consider how people mistakenly confuse the two approaches
in analyzing the stock market.
A Conversation with George
(This is a composite conversation with real people, but not a
specific individual. It is accurate, in that it reflects the
feelings of many, but it is not an actual dialog.)
I got a call from George, an intelligent market observer who
reads a lot.
G: What do you think about the market? I am getting worried
after the big move.
J: Are you all-in?
G: Are you kidding? I am not in at all. I just heard a
prediction that the S&P 500 is going to 400.
J: Who said that?
G: Someone with a system. He said to ignore predicted earnings
because analysts are biased. He uses only actual known earnings.
Everything else is a lie. His history went back to the time of Paul
Revere or something -- great research. He also pointed out that we
had to use a "trough multiple" -- or -- just a second -- that was
what we used last year. Now we should use the peak multiple, but
they are actually both the same. You multiply $50 in S&P
earnings by 8, and that is what the market should be. Do you know
what the P/E ratio was in 1840?
J: Uh.....no. May we return to the 21st century?
G: I thought you were a scholar. But OK.
J: It has taken 18 months to regain the pre-Lehman levels. The
selling in late '08 and early '09 were predictions of another
depression and a total failure of the Obama Administration. It has
taken this long to return to a semblance of sanity.
G: So what? There is always a correction after a big move. We
are going lower. Much, much lower.
J: Markets do not go straight up, but we are just getting back
to a starting point, something that I described as an "initial
target" at the start of 2009. Nearly every indicator, except
employment, is better than it was then. Markets are about earnings,
and earnings are showing great strength.
G: I think that the market will move sideways for many years --
or maybe sell off.
G: The economy cannot grow without the consumer. I read that
consumers are 70% of the economy and that they are tapped out,
spent up, unemployed, and leveraged to the hilt. the market is
going nowhere without the consumer.
J: The mainstream economic forecasts.....
G: Forecasts! Don't give me that! Those economists know nothing!
They know nothing!
They did not see it coming. They use models. That is just
fantasyland. Everyone knows that models have built-in error.
Economists know nothing. Obama knows nothing. Congress knows less
than nothing. These are the guys who got us into trouble and I am
not going to believe them.
J: OK. Let us put aside the political and methodological
G: It is just the truth. We will be lucky to stay sideways in
this market. I have actually been checking out the price of
J: How is your ammo?
G: Locked and loaded.
J: Returning to the market, you just told me what you expect.
How did you arrive at those conclusions?
G: I read some great sources, including many who predicted the
crash. They explain that the forecasters are all wrong. None of the
models worked. The guys I read all saw it coming.
J: Did any of them change their opinions at any point? After the
fall of Lehman? After the government policy actions? After
improving economic data?
G: Change? No way!! They got it right. Lehman and that other
stuff made no difference.
As an investment advisor, how do you help someone with this mind
set? There are several very fundamental problems. Let me take them
one at a time.
Predictions are often very general and completely ignore the
time frame. We started seeing recession forecasts in 2004 or so.
Keeping in mind that a recession happens (on average) every five
years, what should be the shelf life for these predictions? Those
who grew impatient started arguing their own definitions for what
constituted a recession.
Predictions involve modeling. The difference is that for many
people the models are poorly specified, based on little
information, and cannot be tested. Consider George's assertions. He
actually made a commonly-accepted statement that has
hidden modeling and assumptions.
Economy and the consumer.
Those who cite the 70% statistic do so while ignoring a long list
of assumptions. Most consumer spending holds up even in
recession. Not everyone is affected, and even those who are have
various means of support. There are also new population entrants.
Finally, there are times when business takes the lead, and we
might be in such a cycle.
Economy and the stock market.
Those who point to economic concerns think that the market is a
GDP future. This is quite clearly not correct. Many companies can
and do thrive even in adverse economic circumstances.
My point is not that the predictions from George's pundits will
be wrong. The point is that the reasoning is very sloppy.
Anyone making a prediction is using a model!
Those who make predictions while criticizing modelers simply
lack the requisite training. A professional modeler identifies
risks and possible error. Every modeler understands that the result
is a simplification of reality. Good modelers test results against
reality and suggest error ranges.
Compare this highly professional approach with the "laundry
list" method of many pundits who have no formal training in models.
They cite lists of "headwinds" and make predictions without time
frames. Those who rail against models and the "folly of
forecasting" while still making predictions are still doing
modeling, but doing it very poorly.
There will be an earthquake some day.....
Investors should be paying attention to the analysis of the
causes of the financial crisis. There is a complex story including
many factors. Understanding what happened could be important to
making the right investment choices.
So how should I explain this to George, whose mind is made
Is Trade a Plus or Minus for U.S. Growth?