The Folly of the Macro Investor

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.