Managing a portfolio
Self-delusional at best
Here’s my thought: Pay no attention to economic forecasts and ignore all predictions as to where the stock market will be in the next year or so.
How can I say such a blunt thing? Well, let’s see.
It can’t be that simple
In the in the Berkshire Hathaway Chairman’s letter for 1988 Buffett wrote: “As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market. Rather, they reflect an opinion about long-term business prospects for specific companies. We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.”
According to Roger Lowenstein, one of Warren Buffett’s guides in relation to buying companies was to “pay no attention to macroeconomic trends or forecasts, or to people’s predictions about the future course of stock prices. Focus on long-term business value – on the size of the coupons down the road [referring to Buffett’s idea that ‘owner’s earnings’ or Free Cash Flow performed essentially the same role in valuing common stock as coupons performed in valuing bonds]”. (Lowenstein, Buffett, The Making of an American Capitalist, 1995,2008) p325.
Ok, that’s just one man. Surely some targets are useful.
In a lecture given by Benjamin Graham on November 15, 1963 at the Town Hall, St. Francis Hotel, he commented on predictions saying: “I would like to point out that the last time I made any specific stock market predictions was in the year 1914, when my firm judged me qualified to write their daily market letter, based on the fact that I had one month’s experience in Wall Street. Since then I have given up making predictions.” (Graham, 1963, p.7) (Emphasis added)
In 1932, Alfred Cowles established the Cowles Commission for Research and Economics. Robert Hagstrom writes: “In one of the most detailed studies ever conducted, the commission analyzed 6,904 forecasts from 1929 through 1944; according to Cowles, ‘the results failed to disclose evidence of ability to predict successfully the future course of the stock market.’” (Hagstrom, Investing – The Last Liberal Art, 2000)
After referring to his experience in 1949 of looking back at the forecasts made in 1948 regarding radio stocks, Graham says: “How did these expensive research staffs, with their ‘field research’, miss out so badly? They did miss out badly, because I could go on citing such examples indefinitely. Was it partly the “33 1/3” passing grade in economics also applied to market forecasting? Or were some of these staffs more occupied with research than in making investment of their own? Much more likely, their findings are entirely all right, but they, and all of us fail to realize that they are undertaking the impossible. Dwight W. Morrow once said, when asked when he would know that the deflation of the “thirties” was over: ‘I will tell you six months after it has happened.’ Now that is the real truth.”
George Soros writes: “My financial success stands in stark contrast with my ability to forecast events.” He refers to both financial markets and the real world. He says: “Even in predicting financial markets my record is less than impressive: the best that can be said for it is that my theoretical framework enables me to understand the significance of events as they unfold – although the record is less than spotless. One would expect a successful method to yield firm predictions; but all my forecasts are extremely tentative and subject to constant revision in the light of market developments. Occasionally I develop some conviction and, when I do the payoff can be substantial; but even then, there is an ever-present danger that the course of events fails to correspond with my expectations.” (Soros, The Alchemy of Finance, Reading the Mind of the Market, 1987,1994) p301. (Emphasis added)
At the Legg Mason Capital Management – Thought Leader Forum in 2011 Daniel Kahneman is reported to have said: “It’s not that the pundits do badly. It’s not that the television chains made a mistake. They didn’t make a mistake. The world is incomprehensible. It’s not the fault of the pundits. It’s the fault of the world. It’s just too complicated to predict. It’s too complicated, and luck plays an enormously important role.” http://www.thoughtleaderforum.com/957443.pdf
Kahneman refers to studies by Philip Tetlock concerning expert predictions. Tetlock examined 80,000 predictions on political and economic trends. “The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of the three potential outcomes.” Kahneman’s conclusion is that: “Those who know more forecast very slightly better than those who know less. But those with the most knowledge are often less reliable. The reason is that the person who acquires more knowledge develops an enhanced illusion of her skill and becomes unrealistically over confident.” (Kahneman, Thinking, Fast and Slow, 2011)p.219. (Emphasis added)
Tetlock’s conclusion was that the more famous the forecaster, the more unrealistically overconfident they become and the more flamboyant and ultimately the more often they were wrong in their forecasts. (Kahneman, 2011)p.219. (Emphasis added)
Reflect on how famous forecasters earn their stripes. One or two seemingly prescient calls by a market strategist, an economist or academic author can make their reputation. In truth, the prescient call was more a matter of luck than talent. Understanding that helps the investor to take all predictions with a large grain of salt.
Kahneman writes: “It is wrong to blame anyone for failing to forecast accurately in an unpredictable world. However, it seems fair to blame professionals for believing they can succeed in an impossible task. Claims for correct intuitions in an unpredictable situation are self-delusional at best, sometimes worse.” (Kahneman, 2011) p241. (Emphasis added)
Galbraith wrote in A Short History of Financial Euphoria that there are two kinds of forecasters: those who don’t know how to do it and those that don’t know that they don’t know.
Models, computers, AI and all that
Surely the digital age and algorithms and computer models can solve the problem. I don’t think so. No model can predict where stocks will be in short to medium term; that is, from a matter of months to ten years or more. All models reach conclusions as to whether the stock market is expensive or cheap at a point in time and posit from there that future returns will be less or more, respectively, as a result. The models variously use the stock market’s earnings yield compared to the yield on treasury bonds (Fed Model), the level of the market’s price to earnings ratio to average levels (traditional model), dividend models, market cap to GDP, depreciated replacement cost or the market’s Price/Earnings ratio to a multi-year moving average usually adjusted for inflation (CAPE and others). I have offered my criticism of CAPE here. The reason for this is that any prediction based on models can be overwhelmed by what happens in the real world which includes things like the economy, geopolitical events, animal spirits, Mr. Market and inflation.
What about interest rates?
Today there is a lot of talk about the impact of low interest rates on stock prices. Robert Shiller has written: “Although interest rates must have some effect on the market, the behavior of the stock market is not just a predictable reaction to interest rates. There is a lot more going on in the stock market, and a lot more for us to try to understand about its behavior.” (Shiller, Irrational Exuberance, 2005 Second Edition) p9.
What are investors to do?
The first thing to do is reread the quote from Warren Buffett that I started with. Investing is all about determining the “long-term business prospects for specific companies.” We want to buy those companies at “very attractive prices”. We are looking at price vs value.
As John Templeton says in his Maxim 14: “Too many investors focus on ‘outlook’ and ‘trend’. Therefore, more profit is made by focusing on value.”
In his Maxim 4. 1982 version Templeton says: “The time of maximum pessimism is the best time to buy. And vice versa. Buy when published predictions reflect an unusual level of gloom and sell when the consensus is unusually optimistic. This applies to share prices generally and also for particular industries.” (Emphasis added)
As for selling under conditions of optimism I offer my thoughts here.
As a general rule we need to minimize the need for prediction in the investment process. One should be able to avoid having to rely on any forecasts about the economy, predictions about the outlook for the market over the coming year and projected sales and earnings in the next year. One will have to make an assessment or business judgment as to whether a company will almost certainly make improved earnings and Free Cash Flow in the years to come on a five or even a ten year horizon. Of course that is a prediction of a kind. But, it is not based solely on a quantitative analysis. It is based on a business analysis, a qualitative analysis of the company, its business franchise, its management and its sustainable ability to generate substantial Owner Earnings.
As an aside, I would note there is a world of difference between an index fund ‘buy and hold’ investor and the investor who uses index/ETF smart beta/factor funds to try to time the market by switching back and forth between an index equity fund and a bond fund (except careful rebalancing), or between varieties of sector index/ETF smart beta/factor funds. Market timing by way of market prediction is a fools’ game and timing by way of value is more difficult for market sectors or the market as a whole, than for individual stocks. You can’t come up with an estimate of intrinsic value for an ETF.
So, back to what I wrote at the beginning. Pay no attention to economic forecasts and ignore all predictions as to where the stock market will be in the next year or so.
Investing involves having a sound process. Read more about constructing a portfolio in the Motherlode Part 7: Building and managing a portfolio
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