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The Folly of the Macro Investor

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Have you ever thought about how many moving parts there are in the world of human affairs, or the infinite permutations those moving parts have to interact with each other? How will these interactions play out? How will they affect the world economy, particular industries and businesses, the financial markets — and ultimately your portfolio?

This is “macro.” On paper, it’s perfectly sensible: The more we are able to understand the implications of what’s going on in the world, the better we can position our investments to either capitalize on the opportunities or hedge the risks embodied in those implications.

Thematic and top-down, macro research was the environment I grew up with during my 20 years at PaineWebber and it remains the cornerstone of Wall Street research and a primary focus of the financial media. The problem is — it doesn’t work.

The evidence floods my inbox every day: hundreds of pages of informative research reports, white papers and commentaries of all variety. I’ve read these reports for decades, and continue to read them today. They all share one common attribute: With extraordinarily rare exception, I feel no more confidence about a course of action when I’m done reading than before I began.

Hedged Bets

Consider the following excerpts from a recent report of a well-known, highly respected firm; one with enormous resources, and experienced, capable and extremely intelligent analysts. The report summarizes their key forecasts to investors, and is presented by the various heads of their research team. The outer time-frame for all of these forecasts? Twelve months.

On the economy: “Supply-side growth pessimists are faced by optimists for growth who point out that periodic waves of innovation have always come about and should continue to do so.” On U.S. markets: “We are long-term positive on U.S. equities, but three factors keep us cautious in the short term.” On Europe: “We would view further market falls as possibly creating attractive entry points.” On market behavior: “With the situation unlikely to normalize quickly, it would be wise to expect further bouts of volatility in coming months.”

Only by channeling his inner Charles Prince was the chief investment officer able to commit to even a temporary course of action: “But as for the time being we still like moderate yields and economic growth rates, we will keep dancing.”

What connects all these quotes is the underlying uncertainty — the hedge in every statement. This isn’t meant as a criticism of the authors, or their firm — these are serious, experienced, bright and dedicated individuals who are doing their best to lay out the world as they see it. The problem is that even looking forward to a period as short as 12 months, uncertainty is so baked in the cake of the future that an honest macro appraisal cannot but hedge itself.

There have always been individuals who made notable and successful macro forecasts. Recent examples include John Paulson, Meredith Whitney, and Elaine Garzarelli; they made dramatic and accurate calls respectively on the 2008 mortgage collapse, the risks in banks just prior to the financial crisis, and the 1987 crash. We wanted to believe that they had cracked the “macro” code — and showered them with attention, money and celebrity. But like others before them, they turned out to be one-hit wonders. All except Paulson have slid to the periphery of the investment world, and of the billions Paulson still manages, a growing percentage of it appears to be his own money.

Bombing Out

A famous story about economist and Nobel laureate Kenneth Arrow illustrates the paradoxical but persistent attraction we have to macro forecasts. Posted as a statistician in the U.S. Army Air Corps during World War II, Arrow realized that the 30-day weather forecasts used to schedule bombing runs were completely worthless, and he filed a report with that finding up the chain of command. He was informed that the general knew they were worthless, but still needed them for planning purposes.

David Dreman, investor and columnist for Barron’s, conducted a study of 94,000 analyst’s earnings estimates between 1973 and 1991, publishing the results in the Financial Analysts Journal. He reported that the average difference between the estimates and the actual earnings was an annualized 44%. Given the overwhelming evidence, it would be logical to assume that investors would immediately ignore or severely discount the value of quarterly earnings estimates. That assumption would be incorrect: Investors, like generals, continue to demand forecasts even if they’re worthless.

Despite its rational foundation and periodic successes, macro doesn’t address the primary challenge of investing: What are we supposed to do when events play out in a way we were not anticipating? How do we avoid the terrible circumstance of being stranded in an extremely challenging market environment with only our emotions to guide us?

Nobel Laureate Harry Markowitz understood this dilemma and made a notable choice. Markowitz is the creator of the “efficient frontier,” a brilliant and popular tool used by many large investors to resolve the perpetual dilemma of how to diversify a portfolio in order to get the greatest return with the least risk.

However when it came time to invest his own money, Markowitz realized that despite the brilliance of the efficient frontier, the strategy was not right for him. He needed a simpler and more emotionally comfortable path. As related in the book “Risk Savvy” by Gerd Gigerenzer, Markowitz said: “I thought, ‘You know, if the stock market goes way up and I’m not in it, I’ll feel stupid. And if it goes way down and I’m in it, I’ll feel stupid.’ So I went 50-50.”

The important lesson is not that Markowitz didn’t trust his own creation. Markowitz is a brilliant academic who knew he had a unique and valuable insight. But he had enough self-awareness and emotional honesty to acknowledge that in his own situation it was more important to have simplicity over sophistication and comfort over competitive returns.

How to React

Outside the investment world, in the familiar terrain of everyday life, it is well understood that success and failure have little to do with our ability or inability to predict the future. Collective or individual, the stories that resonate with us relate to how someone responded to a challenge.

Moreover, in the recounting, we find that the outcome is almost always the result of (or of the lack of) preparation, experience, temperament and a little (or a lot of) luck.

Ernest Shackleton failed to reach the South Pole in 1915. That historical fact has become an asterisk because of what he accomplished after his ship was crushed by the ice and the expedition stranded. After exhausting every conceivable option, Shackleton sailed a 20-foot lifeboat 800 miles across very dangerous waters to the closest inhabited island, walked 32 miles over a mountain range to reach the island’s only outpost, commandeered a ship and returned to Antarctica to rescue his men.

Harry Markowitz was smart enough to know that the ultimate fruits of investing can take decades to harvest — yet the investment industry continues to focus on time frames that relate more to the news cycle than the investment cycle. He chose a strategy that can weather the inevitable market swings — the investment industry tries to predict them. He chose simplicity — the investment industry pushes “alternative” strategies built on complexity.

Examples of individuals who successfully responded to challenges in their lives are all around us — reinforcing the value of insight, wisdom, courage, patience, perseverance and the willingness to commit to a plan despite the uncertainty. These are the qualities that investors want and deserve from those who offer advice and counsel.


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