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Markets: The Folly of Forecasts
New York: August 29, 2005
By John R. Stephenson

The world of investments is filled with forecasts. Bankers, strategists, analysts and gurus all predict where the economy is going and what represents a reasonable target price for a stock. Through slick marketing, Wall Street has positioned itself as expert in predicting the markets. In fact, the very essence of the business of Wall Street is to convince you, the investing public, that they alone have the inside track and to ignore its advice is tantamount to economic suicide. Catchy slogans such as "Retire Rich", or "Ten Must-Have Stocks For Your Portfolio" are neatly packaged to make you believe that Wall Street professionals hold the keys to your economic well-being. But the results speak for themselves — they are disappointing.

SmartMoney.com has been tracking the predictions of various market forecasters between 1997-2002 including some of the really big names such as Abby Joseph Cohen (Goldman Sachs and Co) as well as Bill Gross (PIMCO) and many others. This was a time where the stock market showed some incredible ups as well as downs. In short, an excellent time to test your metal as a stock market prognosticator. The results? The average batting average of these gurus over the last five years has been a disappointing 23.6% accuracy. Yet, forecasts and their mistakes persist — but why?

Forecasts and forecasting is at the heart of the investment process. We use these forecasts like a captain uses a lighthouse on a stormy night — for navigational purposes. But if forecasts are disappointing what sense does this make for our investment plan? How do we as investors navigate when the skies are so stormy and why do forecasts persist when their track records are poor? Behaviorists believe they have the answer which lies in the concept of anchoring. In essence, in the face of an uncertain future, we human beings would rather cling to a forecast (something definitive) regardless of how irrelevant than navigate the choppy world of investments without a compass. While life may abhor a vacuum, investors abhor uncertainty.

As it turns out, these so-called experts are fallible just like the rest of us and human psychology is at the core of the problem. The typical culprits? Overconfidence and over-optimism enter the fray to ruin the day. Lately, more light has been shone on the psychology of investing rather than just the mechanics of it. So much so, that in 2002, the Nobel Prize in economics went not to an economist but rather to a psychologist, Dr. Daniel Kahneman, for his insights into behavioral finance. Behavioral finance is nothing more than the merging of the field of human psychology with the science of economics. And the results are fascinating. Rather than being purely rational beings that try and maximize our wealth with every choice, we are highly irrational beings. But for Dr. Kahneman, the true insight was not merely that we are irrational but rather that we are predictably irrational — we make the same mistakes over and over again.

And so it is with stock analysts, strategists and economists that it is our human failings that cause us to be overconfident in our predictions and to believe that this time it is different. In essence, people are much too sure in their ability to predict. Studies confirm the presence of overconfidence in investors and stock analysts. According to a recent study, some 68% of stock analysts thought that they were above average at forecasting earnings and yet by definition only 50% could possibly be above average. For money managers, overconfidence is worse.

Bubbles form because investors become convinced that trends will persist indefinitely. A study by Dalbar confirms such behavior amongst investors. There is a widespread tendency to buy into yesterday's hot performers. In short, emotion clouds reason and investors become caught up in a downward spiral of buying high and selling low which hampers their long-term investment performance.

But such foibles aren't limited to the world of stocks and bonds. The latest fad that investors have seized upon is housing. Homebuyers in many parts of the country are making the same mistakes that stock analysts and economists have made — that is projecting into the future the stellar returns from past performance. The longer a trend is in place the more confident we become that it will continue — especially, if we as investors are directly benefiting from that trend.

Housing is hot and perhaps it will get hotter, but don't bet on it. The Economist magazine recently reported that some 42 percent of all first time home buyers and 25 percent of all buyers in total have entered the market last year with no money down. Talk about leverage. The reason? These homebuyers are betting that the trend will continue and that their over-leveraged asset will continue to escalate in value and that they will be able to flip it for a tidy profit down the road.

In Jackson Hole, Wyoming, the soon to be departing central banker Alan Greenspan and arguably the most powerful man on Wall Street took aim at the housing market. In prepared remarks he said: "The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes." But what asset prices is he talking about? The only obvious one is housing. He later went on to say: "Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent." While confusing, it appears clear that the chairman of the U.S. Federal Reserve (central bank) is warning investors that house prices could go down as easily as they continue upward.

Bubbles, whether in real estate or stocks, have similar characteristics. Investors at first refuse to recognize a loss once the trend starts to reverse. Hey, why sell at a loss is the common reasoning. But as homes are foreclosed in your area, then the psychology changes dramatically — what could only once go up in value, now has nowhere to go but down. All the while, inventories of available housing begin to build and the spiral continues. Prices go lower.

While trends persist and often for longer than most people thought, they never continue indefinitely. With 90 percent of the U.S. population participating in the housing market, maybe it's time to take a long hard look at your investment and ask yourself: would I be willing to hold this asset if the value (price) were to decline by 20% or more? If the answer is no, perhaps it's time to consider lightening up on real estate as it appears more and more likely that the U.S. central bank is gearing up to prick the bubble that appears to have formed in real estate.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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