The Perfectly Dangerous Thing Your Clients Want

Michelle Pfeiffer was and is a major movie star. People magazine put her on the cover for its first “50 Most Beautiful People” issue in 1990. The New York Times, no less, called her “devastatingly gorgeous.” So when Esquire magazine’s December 1990 cover asked “What Michelle Pfeiffer Needs …,” the answer printed on the inside front cover—“Is Absolutely Nothing”—seemed superfluous at best. However, as it turned out, she needed a lot of help to look like she did on that cover, which was perfect.

As Danielle Nicole DeVoss and Julie Platt of Michigan State reported, an Esquire editorial memo to a photography retouching company included detail about what needed to be done to make Ms. Pfeiffer seem perfect: “clean up complexion, soften eye lines, soften smile line, add colour to lips, trim chin … soften line under ear lobe … add hair to top of head.” Gorgeous wasn’t enough. Esquire—like many of our clients—wants perfect.

By any measure, 2013 was a great year for stocks. Yet anybody who tried to diversify or hedge meaningfully got hurt, at least in comparison to those who were all-in on domestic equities. The Global Dow Jones Index was up over 27% for the year but the Global Dow ex-U.S. was up “only” about 9%. Long-term Treasuries were down 15% for the year and corporate bonds were down 7% despite a generally constructive credit story. Municipals, agencies and mortgage-backed securities all finished in the red; REITs were flat. Gold got crushed and other commodities performed poorly too. Meanwhile, there were more stocks in the S&P 500 that returned 60% or more for the year than stocks that lost money.

The key to “beating the market” in 2013 was thus simple if incredibly dangerous: no bonds, no shorts, no hedges, no diversification and no tactics. But because of my commitment to diversification, I would never advocate that sort of approach. Thus it’s a given that any portfolio I constructed would underperform U.S. stocks in 2013. A terrific and diversified portfolio with excellent overall performance wouldn’t necessarily look all that great to clients. It wouldn’t have been perfect or even a reasonable facsimile thereof.

That’s why managing client expectations is so important. Clients tend to assume that we should be able to forecast markets like 2013 in advance. Oh that it were so.

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.

A CXO study of that data determined that the forecasted probability of recession for a quarter explained absolutely none of the stock market’s returns for that quarter. The data even 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 bias in that bear markets lead to bearish market forecasts and vice versa with no predictive power whatsoever. A 2005 Dresdner Kleinwort study of market analysts showed the same thing, entirely consistent with a long line of academic research (most prominently from Philip Tetlock) establishing the lack of value provided by so-called “expert” forecasters across fields and disciplines.

Quite obviously, the “experts” are like the rest of us—they tend to worship at the altar of price momentum in the church of what’s happening now. Markets, like analysts and investors, tend to assume that tomorrow will look a lot like yesterday, moving as a herd toward what is often the wrong conclusion.