Dancing with the Trend

The Reign of Error

In 1987 a book was written, entitled “The Great Depression of 1990,” by Dr. Ravi Batra, an SMU professor of economics.  Sadly, I bought and read that book back then.  Batra was claimed as one of the great theorists in the world and ranked third in a group of 46 superstars selected from all economists in American and Canadian universities by the learned journal Economic Inquiry (October 1978). The foreword was written by world-renowned economist Lester Thurow, who said The Great Depression of 1990 is crucial reading for everyone who hopes to survive and prosper in the coming economic upheaval.  The title for Chapter 7 was The Great Depression of 1990 – 96.  Not only did he pronounce the beginning of it, he also proclaimed to know the end. The 1990s saw the largest bull market in history, with the Dow Industrials rising from 2700 to over 11,000 during the decade of the 1990s.  By the end of the decade we were flooded with books about the never ending bull market such as: Dow 40,000 by Elias, Dow 36,000 by Glassman and Hassett, and Dow 100,000 by Kadlec.  From 2000 until early 2003, we witnessed a bear market that removed most of the gains of the previous ten years with the Dow Industrials back down to about 7350.

“We are making forecasts with bad numbers, but bad numbers are all we have.” Michael Penjer

These forecasts were dead wrong, however, I’m sure the authors sold a lot of books.  The bad news in the stock market did not end after the bear market from 2000 to 2003, by March, 2009 the Dow Industrials was below the level of the previous bear by another 8%.  Agencies whose duty is to make forecasts were almost universally wrong during the 2006-2007 period with forecasts of the economy, the markets, the world outlook, all positive; even the ones who weren’t quite as rosy, were only modestly so.  The business magazines were the same.  How many forecasts do you find yourself reading and listening to?  Did you ever research to see if any of them ever turned out to be correct?  Or even close?  Incidentally, you can buy a copy of “The Great Depression of 1990” from Amazon for less than $5; a price entirely too high.  One reviewer commented that his timing was off. No kidding!

Finance is not the same as physics in that no mathematical model can fully capture the large number of always changing economic factors that cause big market moves – the financial meltdown of 2008 is an example.  Emanuel Derman says, “In physics, you’re playing against God; in finance, you’re playing against people.”  The parallelism between physics and finance has gained support from author Nassim Taleb, who says, “It doesn’t meet the very simple rule of demarcation between science and hogwash.” Whether invoking the physicist Richard Feyman or the late Fischer Black, the use of mathematical models to value securities is an exercise in estimation.  Derman further states, “You need to think about how to account for the mismatch between models and the real world.”

Science is a great many things, but in the end they all return to this: science is the acceptance of what works and the rejection of what doesn’t.  That needs more courage that we might think.”  Jacob Bronoski

Long Term Capital Management was started by John Meriwether, who had a great following along with Myron Scholes and Robert Merton, two famous economists.  Together they grew LTCM into assets of over $130 billion, using a model they claimed would achieve exceptional returns without the usual risk.  That alone should have been all the warning anyone needed.  In 1997, their model did not do well, and by mid-1998 they had lost all of it; they had borrowed over a trillion dollars to make investments.  The story ended in September, 1998, when the New York Federal Reserve Bank led a group of organizations to step in and bail them out; shortly thereafter there was no more LTCM.  Academics with sophisticated models are a dangerous lot.  And here’s the best part, just before the demise, Myron Scholes and Robert Merton won the Nobel Prize for economics for their efforts in financial risk control.

LTCM was not alone; stories of hundreds of funds have gone out of business after short periods of exceptional success.  Rogue trades were rampant.  Remember Nick Lesson of Barings Bank?  How about Jerome Kerviel of Societe Generale or a host of large banks during the period?  The list is long and growing.  Enron, WorldCom, Global Crossing were just a few large companies who went bankrupt taking their employees pensions and investments with them.  I don’t recall anyone ever anticipating any of these failures; forecasters never do.

After the inflationary decade of the 1970s, the price of gold was soaring.  In the early 1980s, forecasts of gold reaching unbelievable heights were everywhere.  They were supported with the facts that gold’s fixed value was released in 1971 and it was free to trade, and trade it did. The Hunt Brothers had bought a large portion of the silver market.  No forecaster saw anything but higher prices. I recall buying three 100oz. bars and wishing I had more money to buy more.  And now the forecasts of gold going to the moon are everywhere.  At what point will we start to believe that forecasting is a hoax?  This blog is about the stock market, where the forecasting business is huge.  I can tell you this; stock market forecasters are no different than economic forecasters.  The ones who get lucky with a forecast are the ones who have yet to be wrong.  I think the worst of them are the ones I call outliers (not to be confused with outlaws); these are the ones who through some stroke of luck make a forecast about something big and it turns out to actually happen.  However, rarely in the exact manner of the forecast, but that is soon forgotten as he is paraded through the financial media as the guru of the year.  They start newsletters, hold conferences, and embark on periods of more and more forecasts because they are now experts.  Yet, most rarely make another correct forecast. 

John Kenneth Galbraith said: “when it comes to the stock market, there are two kinds of investors:  those who do not know where it is going and those who do not know that they do not know where it is going.”

Dance with the Trend,

Greg Morris


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