Whose Investment Prediction Should You Believe?

"The ability to see that some things cannot be foreseen is a very necessary quality." -- Jean Jacque Rousseau.

It's the season when so many analysts participate in a group masochistic ritual: the annual yearly predictions. Like lemmings, they rush to the edge and leap. That they are so often wrong does not seem to deter them from making the same mistake the next year. And there they differ from lemmings, in that they live to repeat the act every year.

As we will see, they often recycle the same mistakes from the previous year, in the hope that this year it will be right. It also helps that they do not lose their jobs if they are wrong. I will also be participating in this tribal rite, although I will take a week off in Mexico, contemplating the tides of both the ocean and the economy, prior to charging once more into the forecasting breach.

But since you are going to be subjected to a lot of predictions, perhaps we should explore the usefulness of some of these forecasts. Today we will look at how well the predictions of mainstream analysts have done over the past few years: basically they have been abysmal. Then we explore why they have been so bad. I will also give you at least two reasons as to why they will be so bad this coming year.

What piqued my interest in this topic, aside from the fact that I am gathering a lot of information to make my own predictions, was a note from Richard Russell and the arrival of the year end Business Week.

Writing on Christmas Eve, Russell led off this observation:

"Early in the year 2001 twenty-two "expert" Wall Street analysts from Louis Ruykeyser's "Wall Street Week" gave their estimates as to where the Dow would be at the close of the year. The estimates ranged from 11,400 to 12,300. But the actual Dow close was 10,021. Not one of the 22 panelists guessed that the Dow would close under 11,000.

"Again, early this year the same twenty-two top analysts gave their estimates as to where the Dow would close in 2002. The estimates ranged from 10,750 to 12,100. As of today, the Dow is at 8,460. Not one of the 22 experts saw the Dow closing below 10,000.

"How can this be? My answer is that none of these analysts is able to recognize change. Although we are in a primary bear market, evidently NONE of these experts understands what this means. Either that or they are so inculcated with the optimism of the last 25 years that they are not able to envision an extended, disastrous bear market."

Then comes Business Week. We are told that BW "polled some of the smartest players on Wall Street." They polled 67 analysts. Only 3 see the Dow going down. A different group of three see the S&P going down and only 2 see the NASDAQ going down. Some of the predictions are interesting. Bernie Schaeffer, for instance, sees the Dow slipping to 6000 by mid-year to rise back to 8500, roughly where we are today. Not a bad guess. I could see that happening. But he also forecasts a rise in the NASDAQ by over 50% to 2200!!! I suppose this will be led by Cisco and Sun? The P/E ratio is going back to 60? What am I missing? (I wonder at what price Bernie would sell me a call at 2200?)

Over 80% of "the smartest players on Wall Street" predict at least a 10% gain for Dow, and the average prediction for the NASDAQ is 20% (or so) rise by this time next year. Should we listen? Should we shut our eyes and buy Vanguard 500 and Janus 20?

Before leaping in, we might want to see how this group did last year. With a little effort, I found the 2002 predictions of 54 of the best and brightest in the last issue of Business Week in 2001. The results suggest we should look a little deeper before plunging back into the market based upon their recommendations.

Of the 54, only four were within 5% of the where the Dow is today. (Schaeffer to his credit was one of them.) Over half thought the Dow was going over 11,000 and a few saw 13,000!!! None of the 54 saw a NASDAQ dropping below 1500 (it is at 1367 this minute), and the average prediction was 2236, or almost 900 points and a 40% difference from where we are today. None saw the S&P below 900.

How could this be? How can the "smartest players on Wall Street" be (1) so wrong and, (2) so consistently wrong as a group? A reasonable person would assume their should be some more randomness - a balance -- in the predictions.

These "smartest players" did not change their views in mid-year. They remain bullish. Yet the stock market tanked. If everyone is so bullish, then who sold? What mass hallucination made these people into raving bulls?

A partial answer is in the make-up of the group. As you look at the firms for which they work, there is a pattern: they are mostly "sell-side" firms. They are in the business of selling stocks or investments to the public. Business Week and Wall Street Week don't go outside this rather self-interested world.

If they had asked Russell, for instance, who has been making rather good forecasts for 44 years, he would have said "down." You don't see a lot of newsletter writers in these groups. I know a number of hedge fund managers who were (and are) quite bearish. You hardly ever see a hedge fund manager in these groups.

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We once asked Arthur Bell, my CPA and friend, about where to get a legal opinion on a certain matter. He asked us whether we wanted a positive or a negative opinion. It seems in a lot of fields the answer you get depends upon whom you ask. These polls essentially ask people who are in the business of selling stocks what they think their business will look like next year.

If you are forecasting a down or flat year, there is not much reason to buy if the only way you can profit is for the market to go up. Bearish predictions do not help sales. Do I think these analysts consciously alter their predictions trying to lure the unsuspecting investor? No, I don't. But I do think they look for reasons the market will go up and ignore reasons which suggest it will go down.

The bottom line is they are more cheerleaders than they are analysts.

(Clients and business partners are requested to skip this next paragraph.)

Full disclosure requires that I admit to being subject to the same myopic limitations. My personal business does not depend on whether the stock market goes up or down. So, from a business standpoint, I don't care. I call it the way I see it. Today I am bearish. But as partners and friends can attest, there has rarely (if ever) been a year when I did not think my business would be better during the coming 12 months. When asked to make predictions about the growth of my business, I would point to all sorts of factors which were bullish. Sometimes I was right and sometimes I am wrong. Even David Tice of the Prudent Bear Fund, as bearish a person as there is, is bullish about the growth of his business.

It Takes Two to Tango

It is not simply the fault of the analysts. A lot of the responsibility goes to investors. People hear what they want to hear. It is one of the reasons we all need outside counsel, whether for business or investment or even for personal decisions: the nature of most people is to be either too optimistic or too pessimistic. It is the rare person who can be totally objective about his future. When you are making investment decisions based upon a person's advice, it is best to know his bias. There is wisdom in a multitude of counselors.

If you only listen to what will make you happy, you are setting yourself up for real problems. There are altogether too many investors who need the stock market to come roaring back so that they can retire. The very real concern about not being able to retire as they once thought they could colors their decisions. They are afraid to cut their losses, and thus let things get worse even as they hope the market will come roaring back and their portfolios will return to its former glorious state. They listen to the sell-side cheerleaders who tell them what they want to hear and then blame them when things don't work out.

Not that there isn't room for blame. There was a lot of fraud in Wall Street. But most of the bad advice and analysis came from simple human optimism: we predict that which will make things better for us. Sadly, we make more predictions based upon hope than cold calculations.

Oh, we use statistics and numbers to make our point. But these are used very selectively, precisely to make our point rather than letting the numbers determine the outcome of the advice. Never underestimate the ability of human beings to rationalize their behavior or their beliefs.

The hardest part of my job as I analyze other investment managers and funds is to sift through mounds of data to figure out what is really important: what will give me a clue as to the future of the investment. In most cases, it is NOT past performance. Trying to keep my emotions and biases from coloring my analysis is difficult, and that is why I like to get a lot of second and third opinions from people I know and trust.

I could quote a number of examples of this ability to rationalize. For instance, Laszlo Birinyi, who runs a stock research firm, told us in late 1999, "this is not a mania, because it is so broad and deep," (New York Times;11-22-99;C14). Or Abbey Joseph Cohen:

"At the end of 2000, the New York Times ran an article, which did include in passing a warning about the risk of a recession, but also included the assertion from Abby Joseph Cohen, the chief United States investment strategist at Goldman, Sachs, that "the market is undervalued, the S.& P. on the order of 15 percent or so ..... the valuations are the best we've seen in a long time" ("The End of the Party, or Is It?" New York Times, December 24, 2000, Section 3, page 1). The article reported her prediction that the S.& P. 500 index would be at 1650 at the end of 2001, compared to its close of 1,305.97 the previous week. (It closed 2001 at approximately 1150, in the summer of 2002, it briefly fell under 800.)" (CEPR; Dean Baker, see more below)

We reach our conclusions and then look for the facts to fit them. We project the types of returns that will allow us to retire in comfort, and then look for someone who will tell us that return is going to happen. If that were not the case, then why is anybody still listening to Abbey Cohen? We listen to these analysts, because we want to believe.

We project positive (or negative) trends out far beyond any reasonableness, because the projection allows us to think we will be better off. This can and will lead to very bad decisions.

This is illustrated by Dean Baker of the Center for Economic and Policy Research who writes: "The country as a whole is now beginning to feel the effects of the stock market crash. As noted above, the stock market crash was the immediate cause of the recession in 2001 and the resulting rise in unemployment. It also has forced millions of workers to radically alter their plans for retirement or their children's education. In October of 2002, the employment-to-population ratio for workers aged 55 to 64 stood more than 3.0 percentage points above the low hit in May of 2000. This increase in labor force participation rates among older workers reversed a thirty-year trend toward declining participation among this age group. Since this jump occurred as the economy was moving from a cyclical peak to a recession, when participation typically declines, there can be little doubt that it is due to the fact that millions of older workers have lost much of their retirement savings as a result of the stock market crash." (http://www.cepr.net/dangerous_minds.htm -- a very interesting paper.)

Can the Dow Really Rise to 11,400?

Elaine Garzarelli made her reputation by calling the crash of 1987. She has missed the recent drops, but not to worry. Things will get better. Very soon, in fact. In 2001, she saw the Dow rising to 11,800 and the S&P 500 to 1380. She now feels her timing was only a little off, and the Dow will rise to 11,400 accompanied by a rise to 1200 on the S&P by the end of 2003. (I choose her because she is the most bullish of the 2003 BW group.)

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This is your basic 33% rise of the S&P 500 in one year. That would be a very bullish year, indeed.

Let's analyze what she is implicitly saying, and why I believe she, as well as the majority of the other analysts, will be wrong again this year. Today the P/E ratio on the S&P 500 is about 45 or so on trailing earnings. Even assuming optimistic forward real earnings, we are still well above 25. Only if you work on reported earnings of the EBIH variety (Earnings before Interest and Hype) and not real earnings can you get back to the area of 20, which is still historically quite high.

However you look at it, Garzarelli is implying that earnings are going to grow 33% over the next year and/or that P/E ratios will stay at these nose-bleed levels or rise dramatically.

If you turn a few pages in your Business Week, you can find 66 "thinkers" giving us their view of the economy in 2003. This is from a very optimistic group of economists. They expect the economy to grow at 3.2%. The average prediction of the growth of corporate profits is 9.7%.

This is in the face of numerous studies which show corporate earnings grow at GDP plus inflation plus dividends. But the S&P 500 is made up of very good companies, so 9.7% is possible.

How can the stock market grow by 33% if profits only grow by 9.7%? Only if the already high levels of P/E ratios get much higher. In my opinion, that is not likely.

If Garzarelli is right about the rise in the stock market, P/E valuations would be off the charts. This is in spite of the mounds of evidence I have written about this year that P/E valuations are now in a reversion to the mean, which will take them back to at least 15, if not much lower. That implies a much lower market, at some point in our future.

Is it possible for the market to rise next year? Of course. But to invest on the hope of a 33% rise on the S&P 500, you have to be aware you are fighting the trend. Stock markets in all of history have reverted to the mean. Bubbles have always corrected.

I have written of studies which show that the stock market is generally random when taken on a yearly basis in terms of prior stock market data. Looking at past performance, P/E ratios or the position of the moon gives us few reliable clues as to how the markets will behave over the next 12 months.

However, the market is NOT random over longer periods of time, and there are primary trends which can be predicted over these periods. The primary trend today is what is called a secular bear market. That is why I believe the stock market is headed lower over the long term. (See the chapter on secular bear markets at http://www.absolutereturns.net.)

But within these primary trends there will be counter-trends, which can last a long time. Could we see a rise in the stock market next year? Absolutely. I can think of a few reasons for the market to rise, and will write about them in my 2003 predictions. But I also believe that if the market does rise, it will be part of a bear market rally.

But let's get back to the Business Week. If the group of analysts they select to make those predictions was truly representative of the entire universe of analysts, you would find a much wider range of predictions. You can come to only two conclusions from looking at this group: either the market is getting ready to rise in spite of anemic profits growth or there is a built-in bias in the selection of the forecasters.

I think the latter is obvious. You would think the editors of Business Week would get tired of being so wrong and bring a little diversity of opinion to the list. I predict they will do so, but that will be the beginning of the next bull market. (Their cover story entitled the "Death of Equities" in late1982 comes to mind.)

One Thing to Do Today to Help Your Portfolio in 2003

I get letters all the time asking me for a list of what books or newsletters I think they should read. This next year, one of my New Year's resolutions is to modify my web site so that I can list a few articles of the hundred or so I read each week that I think are important. I already have a few suggested books on my web site, and will put more. One of my resolutions is to be of more service to you.

But I cannot provide a link to one of the best sources of wisdom, as it is not free. If you are interested in developing a real understanding of the markets, I suggest you spend $250 (six months for $150) and subscribe to Richard Russell's Dow Theory Letters. He writes a daily commentary, as well a monthly print letter, and has been writing continuously for 44 years. If you really want to understand how the market works, read his current letter each day and then go back into his archives and choose at random a letter from the past. I would normally say that Richard has forgotten more than most of us will ever know, but I am not quite sure if Richard has forgotten anything.

Richard is 78, and gets up at 3 am, reads voraciously and then just writes on what he sees as important that day. The breadth of information he writes about is staggering. After a year of this, you will start to see the ebb and flow of the markets in an entirely different manner. It will be the best $250 of investment information you will get. http://www.dowtheoryletters.com is his web site.

Make a Few Resolutions

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I love this time of year. I am the eternal optimist. I can honestly say that I have never faced a New Year when I did not think the next year would be better than the last. Some years I am right and things go very well, and others are not as good. But those off years are simply another reason for me to think that the next year will be better. And they usually are.

I have a hard time remembering when I have been more optimistic or excited about a New Year than I am today. Not because I think the stock market is going to the moon or the economy will grow at 4%, but because I believe that I will be able to accomplish more of my personal goals this year. You can't let the economy or the markets control your lives. It's like Spring and Baseball. You gotta believe.

I have never been big on New Year's resolutions, but this year my good friend Mark Ford of Early to Rise has convinced me of their importance. They let you focus on things that can make your life better, rather than letting yourself be carried along by the tides. I always instinctively have business goals, but he makes a point that we should sets goals and take control of all areas of our lives. "...you should have four categories: health, wealth, personal, and social. In each category, you might have assigned yourself five or 10 specific objectives."

This year, my wife and I are going to sit by the ocean on New Year's Eve and set our goals for this next year. I am really looking forward to that special time.

Let me say that I am truly grateful to you, dear reader, for letting me come into your life this past year. The growth of this letter to over 1.5 million readers from only a few thousand in 2000 has been one of the most amazing things of which I have ever been a part. I have a world of friends like you I write to every week, and each new reader is another new friend. It is allowing me to re-structure my business in ways I could only dream about a few years ago. Because of you, I get up each morning excited about my work. Thank you from the bottom of my heart.

May you have a very Happy New Year, and may this year see your dreams and resolutions come true.

Your expecting the best year of his life analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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