Finding Value in a Loser’s Game

As John Kenneth Galbraith famously pointed out, we have two classes of forecasters: those who don’t know and those who don’t know they don’t know

Economic forecasting is really hard.  There are simply too many variables and too much uncertainty (Donald Rumsfeld’s infamous – but accurate – “unknown unknowns”) for forecasting to be anything like easy.  Indeed, as the Yoram Bauman, the Stand-Up Economist humorously points out, economists have correctly forecast nine out of the past five recessions.

That’s why the results of a recent CXO study should not be surprising.

Since 1990, the Federal Reserve Bank of Philadelphia has conducted a quarterly Survey of Professional Forecasters, continuing research conducted from 1968-1989 by the American Statistical Association and the National Bureau of Economic Research. The survey asks various economic experts their views of the probabilities of recession for each of the following four quarters and comes up with an “Anxious Index” reflecting those asserted probabilities.

The CXO study determined that the forecasted probability of recession for a quarter explained absolutely none of the stock market’s returns for that quarter.  In fact, the data suggest that the forecasts were a mildly (if not materially) contrarian indicator of future U.S. stock market behavior.

The survey reads like a primer on recency bias1 in that bear markets lead to bearish market forecasts and vice versa while the forecasts have no predictive power. 

Based upon the historical record, it’s even a bit surprising that forecasts are attempted at all.

No less an authority than Milton Friedman called Irving Fisher “the greatest economist the United States has ever produced.”   However, in 1929 (just three days before the notorious Wall Street crash) Fisher all but destroyed his credibility for good by forecasting that “stocks have reached what looks like a permanently high plateau.”

Those of you who were around for the tech boom just prior to the turn of the century may remember a book published in late 2000 by James Glassman and Kevin Hassett entitled Dow 36,000.  Its introduction states as follows.  “If you are worried about missing the market’s big move upward, you will discover that it is not too late. Stocks are now in the midst of a one-time-only rise to much higher ground – to the neighborhood of 36,000 on the Dow Jones Industrial Average.”

Sadly, it didn’t exactly work out that way, and a used paperback copy of the book may now be purchased on-line for as little as a penny. It isn’t even worth that much except perhaps as a reminder of the perils of forecasting.

Somewhere around that same time I remember seeing a CNBC interview with a geriatric equities manager who claimed that the “old rules” of investing and risk management no longer applied.  In his view, so much money was flowing into the markets via 401(k) investments and the like and the (“new”!) economy had so fundamentally changed the investment universe that a 100% tech stock allocation was perfectly safe even at his advanced age.

We all know how that forecast turned out.

Market timing efforts – a forecasting strategy based upon one’s outlook for an aggregate market, rather than for a particular financial asset – provide similar results. Without reviewing all the research, suffice it to say that both institutional investors (more here, here and here) and individuals consistently fail as market timers. As John Kenneth Galbraith famously pointed out, we have two classes of forecasters: those who don’t know and those who don’t know they don’t know. 

More specific market predictions do not generally fare any better.  Back in 2000, Fortune magazine picked a group of ten stocks designed to last the then-forthcoming decade and promoted them as a “buy and forget” portfolio of their best ideas. Unfortunately, one who purchased that portfolio would want to forget it. A $100 investment in an equally weighted portfolio of these stocks back then would have suffered a 70% loss over the next decade. 

There are many similar – even worse – examples. In December of 2005, Fortune (again!) was pitching “10 sturdy stocks” that it claimed were “built to last.” Citigroup at $50 and Washington Mutual at $42 featured prominently. Within two years, both of these stocks were much closer to zero than to their levels at publication.

For perhaps the most pertinent example of all, take a look at the range of major firm projections made at the beginning of the year as to where the S&P 500 would end up at the close of 2011 (see chart, left).  Note that the S&P opened the year at 1,257.

 

Strategists from most Wall Street experts predicted market growth for 2011in excess of 10% while only two called for minor declines. Ken Fisher of Fisher Investments called for the decade beginning in 2011 to be as good for the markets as the 1990s were. Overall, most institutional and individual investors were quite bullish and advisor confidence was at a four-year high.  Based upon market performance to this point (and the great performance of 2010), it is once again hard to discount recency bias.

Market machinations over the past few weeks push the point even further.

Much of the time, investing is a loser’s game – with outcomes dominated by luck rather than skill, and high transaction costs.  To illustrate, for most of us tennis is a loser’s game. We do not possess the skills to play well consistently.  Trying harder to make great shots only makes matters worse. 

Most of us are far better off simply trying to keep the ball in play rather than trying to outclass an opponent.  If we keep the ball in play we give the opponent the opportunity to make errors.  That’s a loser’s game — the results are dominated by what the loser does.  On the other hand, professional tennis is a winner’s game, with the outcome based predominately upon the winner’s better shots.  A pro generally needs to do more than just keep the ball in play to succeed.

Since investing is predominantly a loser’s game, if we avoid mistakes we will generally win.

One might be tempted at this point simply to give up and buy index funds.  However, factors do exist that are predictive of market performance over the longer term – PE10, DY10, EY10, earnings growth and even momentum.  But, to be successful, investors need a thoughtful and consistent approach, controlled emotions, and careful analysis of the investment probabilities in order to succeed. 

As I stated in my 2011 Investment Outlook back at the beginning of January (available here), and opposing the Wall Street consensus:

“It is hard to stand alone. It is dreadful to be wrong alone. But doing what is best for clients requires making some tough calls and some tough choices. The herd says ‘Buy.’ I say, ‘Be careful.’”  More specifically:  “The anticipated clear sailing could indeed come to pass and might even last for a good while – perhaps all year. But such favorable market conditions will only last until, inevitably, they don’t. When it comes, I expect the change to be rapid and the drop deep. Economic and market difficulties create a variety of risks and problems. But they also create tremendous opportunities. I therefore encourage investors to remain skeptical, cautious, defensive and opportunistic. In 2011, investors should look to take advantage of the opportunities that present themselves while carefully managing and mitigating risk.”  I believed that then and I still believe it today.

In a secular bull market, one’s primary goal should be maximizing returns.  In a secular bear market (like we face now), the key goal is to preserve capital by mitigating risk.  Doing so is not easy.  Indeed, although my Outlook looks pretty good today, it could all blow up in my face at any time. 

As John Maynard Keynes famously pointed out, “The market can stay irrational longer than you can stay solvent.” So beware of predictions and forecasts – mine included.  Do everything possible to limit mistakes in order to win the “loser’s game.”  Even so, it still makes tremendous sense to plan and prepare carefully so as to find value in a precarious marketplace.

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1 In another context, C.S. Lewis and Owen Barfield coined the term chronological snobbery for the idea that the wisdom, art, and science of an earlier time are inherently inferior to the current conventional wisdom.

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