Leithner & Co Pty Ltd - Forecasts and Reigns of Error

THE OTHER NOTABLE BUFFETT:
A PRIMER FOR VALUE INVESTORS

Part IV

15 November 2003

...continued from Part III

Today Congress is constantly besieged by [special interest] groups seeking benefits from the public treasury. Often these groups control enough votes in many Congressional districts to change the outcome of elections. And so Congressmen find it difficult to persuade themselves not to give in to pressure groups. With no bad immediate consequence it becomes expedient to accede to a spending demand. The Treasury is seemingly inexhaustible. Besides, the unorganised taxpayers back home may not notice this particular expenditure, and so it goes …

The Hon. Howard H. Buffett
The Commercial and Financial Chronicle
5 June 1948

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens … Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch the currency... Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose.

John Meynard Keynes
The Economic Consequences of the Peace (1919)

When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.

Frederic Bastiat, The Law (1850)

In ancient times, seers “read” the entrails of sheep. These days, it takes take little guts to make stock market and economic forecasts – but it takes great intestinal fortitude to ignore them. Yet investors should ignore forecasts and the forecasters who make them. Benjamin Graham and Warren Buffett, outstanding investors whom many celebrate but few emulate, pay (or, in Graham’s case, paid) no attention to “experts” and their predictions. In Mr Buffett’s words, we’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, [Berkshire Hathaway Vice Chairman Charles Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

Investors must never forget that the ability of economists to foretell inflation, interest rates and the like – and of brokers and analysts to foresee financial markets’ general direction, companies’ earnings and the prices of individual securities – is at best very limited and often non-existent. William Sherden, in his excellent book The Fortune Sellers: The Big Business of Buying and Selling Predictions (John Wiley & Sons, 1999, ISBN: 0471358444), reviewed leading research about the accuracy of economic forecasts conducted since the 1970s. He found that economists cannot predict turning points in the economy; their ability to forecast is neither better nor worse than guessing; more powerful computers, more complicated models and greater amounts of data do not improve the accuracy of forecasts; there is no evidence that forecasters’ skill has increased since the 1970s (if anything, it has deteriorated over time); “consensus” forecasts are no more accurate than the individual forecasts that comprise them; the further into the future that economists attempt to forecast, the less accurate their forecasts become; there are no individual forecasters who are consistently more accurate than their peers.

Investors should therefore keep firmly in mind two seemingly-flippant but nonetheless very important laws of economics. The first is that, for every economist, there is an equal and opposite economist. The second law is that both are likely to be wrong. In the words of the influential investor Philip Fisher: “I believe that the economics which deals with forecasting business trends may be considered to be about as far along as was the science of chemistry during the Middle Ages. The amount of mental effort the financial community puts into this constant attempt to guess the economic future makes one wonder what might have been accomplished if only a fraction of such mental effort had been applied to something with a better chance of proving useful.”

Financial journalists and market commentators tend to pitch an undifferentiated message to a conformist audience. They also obsess about assets’ prices (as opposed to their values); and they fixate upon recent developments and opinions, conjectures and rumours about these developments. If investing can render people uncertain and therefore prone to an erratic herd mentality, then the mass media can unwittingly increase the size, accelerate the charge and accentuate the impulsiveness of this herd. And although single lemmings are seldom either criticized or ostracized (psychological safety seems to reside in large numbers, no matter how crazy the actions of the group), lemming-like behaviour often ends in tears. Prompted to a significant extent by what its audience wants to hear, the mass media’s conformist message both reflects and is prone to what Sherden has called a “reign of error.”

James Grant, editor of Grant’s Interest Rate Observer, has written often and eloquently about reigns of error in financial markets. Given the tendency towards faulty prediction, the moral is clear: to suppose that the price (as opposed to the value) of a stock “is determined purely by a corporation’s earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defence of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed.”

Our inability to foresee economic and market developments with any useful degree of accuracy means that we should ignore commentators, economists and others who claim that they have a crystal ball. It does not mean that we should ignore the future. It makes sense to plan for the future not by making particular predictions, but by considering general scenarios of what might conceivably happen – and by reducing the risk of permanent loss if bad things actually occur. It is also wise to remember that, according to Terrance Odean of the University of California-Davis, “psychologists have found that people who are mildly depressed tend to have the most realistic outlook.”