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Investors are best served by ignoring market forecasters
IT IS the start of the new year, and the media and experts like to do outlook pieces. They make for interesting reading. Hopefully, the insight gleaned can help us navigate the markets better. But do such forecasts add value to one's investment process?
In a paper entitled Evaluation and Ranking of Market Forecasters, David H Bailey, Jonathan M Borweiny, Amir Salehipourz and Marcos Lopez de Prado from Lawrence Berkeley National Laboratory and Australia's University of Newcastle NSW, tried to measure the accuracy of forecasters. They built on a 2012 study by the CXO Advisory Group of Manassas which looked at 6,627 market forecasts (specifically for the S&P 500 Index) made by 68 forecasters who employed technical, fundamental and sentiment indicators, from 1998 through 2012.
Messrs Bailey, Borweiny, Salehipourz and de Prado made a few improvements. Forecasts were grouped into short or longer-term forecasts. Longer term forecasts were given more weight because in the short-term anything could happen, as a matter of randomness, but in the long-term underlying trends, if any, tend to overcome short-term noise. In addition, forecasts which were more specific were deemed more significant than general forecasts. Here are the results:
- Of all the forecasts, only 48 per cent were correct - worse than the flip of a coin;
- Two-thirds of forecasters had accuracy scores below 50 per cent;
- About 40 per cent of forecasters had an accuracy score between 40 and 50 per cent;
- About 3 per cent of forecasters fell in the left tail, with accuracy scores below 20 per cent;
- About 6 per cent of forecasters fell in the far right tail, with accuracy scores between 70 and 79 per cent;
- The highest accuracy score was 78 per cent and the lowest was 17 per cent.
Because the accuracy rate of all forecasts was only 48 per cent, the researchers did another test (the Wilcoxon Signed Rank test) to determine whether the occurrences of correct and incorrect forecasts are due to randomness rather than the forecasters' skill. The test result "implies that the number of correct forecasts is just as likely as the number of incorrect forecasts. Therefore, it is very difficult to tell if there is any skill present, and it seems that outcomes are due to randomness".
Also, the distribution of forecasting accuracy is very similar to the proverbial bell curve implying that the outcomes are due to randomness. "In brief, our findings and results show that some forecasters have done very well, even more so than reflected in earlier studies, but the majority perform at levels not significantly different than chance, which makes it very difficult to tell if there is any skill present," they concluded.
Just this week, Larry Swedroe, a principal and the director of research for an independent US wealth management firm US Buckingham Strategic Wealth wrote an article in a bid to hold forecasters accountable for their forecasts. His subject is John Mauldin, who runs a subscription-based newsletter Mauldin Economics.
The website states: "On behalf of subscribers to Mauldin Economics, John taps into his network either directly or through the reams of high-level research he's privy to on a regular basis, to assist in identifying the smartest investments for today's markets. These ideas are then carefully screened and evaluated by a team of ace analysts, with only the best of the best brought to the attention of Mauldin Economics subscribers. This is important to you, because it gives you the equivalent of direct access - just one small step removed - to some of the brightest minds and most successful managers in the world today." On Jan 12, 2015, Mr Mauldin published his Five-Year Global Financial Forecast. His five market forecasts were:
- "A major slide in the JPY/USD exchange rate is almost certain over the next five years. I give it a 90 per cent probability."
- "Europe is headed for a crisis at least as severe as the Grexit (Greece's exit from the eurozone) scare was in 2012, and there will be a resulting run-up in interest rates and a sovereign debt scare in the peripheral countries… I see the deepening of the eurozone crisis as a 90 per cent probability."
- "The world is simply not prepared for China to experience an outright 'hard landing' or recession, but there is a 70 per cent probability that it will do so within the next five years. And the probability that China will suffer either a hard landing or a long period of Japanese-style stagnation (in the event that the Chinese government is forced to absorb nonperforming loans to prevent a debt crisis) is over 95 per cent."
- "All of the above will be bullish for the dollar, which will make dollar-denominated debt in emerging market countries more difficult to pay back. And given the amount of debt that has been created in the last few years, it is likely that we'll see a series of crises in emerging market countries along with an uncomfortably high level of risk of setting off an LTCM (Long-Term Capital Management)-style global financial shock." He attached an 80-90 probability to this.
- "I do not believe that the secular bear market in the United States that I began to describe in 1999 has ended." He gave the probability that the secular bear market would end in five years a 90 per cent probability.
Mr Swedroe pointed out that Mr Mauldin was wrong on all five of his predictions! Note that all five of Mr Mauldin's predictions are sounding alarms about the impending doom of various markets. Perhaps that's a tactic to drive up subscriptions of his newsletters. Afterall, it's in our DNA to be attracted to bad news.
Nobel prize winner Daniel Kahneman in his book Thinking fast and slow said that "the brains of humans and other animals contain a mechanism that is designed to give priority to bad news. By shaving a few hundredths of a second from the time needed to detect a predator, this circuit improves the animal's odds of living long enough to reproduce". Indeed, political scientist Stuart Soroka has illustrated the inverse relationship between magazine sales and the positivity of a magazine's cover, and in a 2014 experiment, a city newspaper lost two thirds of its readers on a day when it deliberately only published positive news!
Well, there's a cost to listening to and acting upon forecasts of impending Armageddon. JP Morgan Asset Management's Michael Cembalest produced a chart which showed the opportunity costs of moving from risk assets to safe assets in response to negative forecasts. He quoted one example. $1 shifted from equities to bonds in 2014 in response to mega-bearish commentary would have underperformed equities by around 40 per cent as the S&P 500, propelled more by earnings growth than by multiple expansion, rolled on.
"The next recession and bear market will have to be quite severe to earn back what was sacrificed along the way. Using rough math, a sustained, multi-year bear market with 35 - 45 per cent declines from peak levels would be needed to reverse many of the opportunity losses shown in the chart," he concluded.
So heed market forecasters at your own risks.
- Hooi Ling is the portfolio manager of a no-management fee Asia fund, Inclusif Value Fund (www.inclusif.com.sg)