4
FORECASTING THE STOCK MARKET
I want to start this chapter by saying that everything I've stated so far regarding our inability to predict applies to the stock market. I'll say it again. Everything I have stated so far regarding our inability to predict applies to the stock market. I could repeat that sentence a hundred times. But most people would forget it the minute they closed this book. Why?
Because people believe that a different set of rules applies to the stock market — that making forecasts is a rational activity.
I'll give you an example. If you had a friend who constantly walked around making predictions about anything and everything that was going to happen in the world, you'd think he was pretty crazy. On the upside, he'd be easy to buy for at Christmas — a set of tarot cards or a ouija board would be just the thing. Let's think of some tags we might give him: psychic, supernatural, psychogenic, telepathic, clairvoyant, occult, palm-reader, crystal-gazer, whacko.
In the world of finance they'd call him an economist.
Let's wind the clock back to March 2009. The world's financial markets were in turmoil, had been for months. The mayhem was triggered by the fallout from the US subprime crisis. For years US financial houses had been packaging billions of dollars of dodgy mortgages and flogging them to banks, hedge funds, insurance companies and municipalities around the world. The problem with these mortgage-backed securities was that they were based on loans granted to people who were incapable of servicing them. With no payments by the mortgagees there was no return to the bondholders. The reason dealers had been able to shift them so easily in the first place was because rating agencies Moody's and Standard & Poor's had unjustifiably been slapping triple-A credit ratings on them.
The whole mess was further complicated by the extensive distribution of credit default swaps (CDSs). These were effectively bets on a business, as defined within the contract, going bust. Some were used as they were initially intended — as insurance. But most were naked CDSs — straight-out bets on an unrelated party failing. It was a bit like taking out life insurance on a stranger and then wishing them dead. By the end of 2007 there was over $60 trillion worth of CDSs circulating the world's financial markets.
Eventually things blew up. And with all the mortgage-backed securities, CDSs, collateralised debt obligations and other synthetic derivatives and financial instruments out there, no-one knew exactly who owed what to whom. The world's financial markets went into a blind tailspin, which leads me into a story I want to tell you.
During the darkest hours of the GFC, on the evening of 5 March 2009, I arrived at an auditorium to address a large group of battle-weary investors. They were guests of a large stockbroking firm. The brokers who'd invited me staged the event each year to reward their clients for their loyal custom. March 5th is a particularly relevant date since the next day the Australian stock market hit its lowest point during the entire GFC. Of course, I didn't know the next day would mark the bottom. But I did know the extreme panic of recent months had been delivering some pretty cheap stock prices.
That evening I took it upon myself to calm frayed nerves — to take a journey back through the centuries and deliver a historical overview of past crashes and subsequent bear markets. I posed questions and framed the answers within the context of how things had panned out following past panics. Was the market cheap now by historical standards? How long did past bear markets last? What had been the market's pattern of recovery following previous crashes, etc., etc. My presentation was peppered with quotes. One I remember was from financier Nathan Rothschild, who said: ‘Buy when there's blood on the streets, even if the blood is your own.' As I've said, I had no idea the next day would mark the low point of the market, but I left the audience in no doubt that stocks were cheap. I also suggested that markets typically bounce strongly from the bottom and that it was quite possible, although by no means certain, that markets could be significantly higher this time next year.
These were the statistics I delivered that night: The nine bear markets the Australian stock market had experienced in the previous 50 years had averaged 15 months in duration. We were already 16 months into this one. Historically the average fall of the general index from top to bottom had been 34 per cent, and the worst had seen a fall of 59 per cent. In this bear market the index was already down 55 per cent.
And here's the clincher: the average percentage gain in the first 12 months after the bottom had been reached was a very healthy 32 per cent. In other words, the market (not always, but typically) climbs strongly and quickly from the bottom.
Now I wasn't claiming to be Nostradamus, but I did place some faith in George Santayana's advice that those who cannot remember the past are condemned to repeat it. I simply figured the odds were becoming increasingly short that we were about to experience a big bounce. The pessimism out there was just so overpowering.
There was a second speaker that night — a high-profile economist regularly seen on cable TV. His presentation started with a brief apology. It turns out he'd stood in the same spot 12 months earlier and told the same group of investors that the market would rise strongly over the course of 2008 and into 2009. Alas, since his last presentation, rather than powering ahead, the market had collapsed by 45 per cent.
Unfazed by the inaccuracy of the previous year's call, he wound up his presentation with a renewed outlook for the year ahead. He confidently declared the market would be flat all year. So how did he go this time? Rather than remaining flat the market actually climbed 53 per cent in the 12 months following that night. The crazy thing is he was invited to present again the next year.
This economist's failed predictions in no way reduced his appeal to audiences. Several months later I attended another seminar where he was voted the best presenter of the day. As I stated earlier, presenters are judged on how confidently their message is delivered rather than on its content.
A popular form of TV entertainment is to pit two economic ‘experts' with opposing views head to head. Who wins the debate? Answer: the articulate, silver-haired, pinstripe-suited gladiator who beats his chest the hardest. Problem is, just as with pro wrestling, there are viewers who actually believe it's all for real.
All this reminds me of a night just before Christmas last year, when I was sitting watching a business show on ABC TV. Over the course of the year the show had run a competition. At the start of the year four leading economic experts and one schoolboy had been asked to predict where the broad stock market index would finish at the end of the year — that is, now. The lowest call by a long shot was from the ‘perma-bear' of the group of economists. This doomster had long been known for his never-changing declaration that the market should be lower. It's an interesting strategy: stick to the same script. In a cyclical game you're going to be correct every now and again. It's a bit like the broken clock with hands that don't move — it delivers the correct time twice a day.
That night they were announcing the winner of the competition, the one who was closest to predicting where the market index would be at year end. And the outcome? The four industry heavyweights were trounced by the fifth contestant, schoolboy Luke Adams.
Now I'm not suggesting that Luke had superior powers of prediction; clearly he was just lucky. But it was interesting to hear the responses from the four so-called experts. I mean these guys were supposed to be intelligent people. Asked why their predictions were so far off the mark, not one of them came up with a legitimate reason (something like, ‘Well, that's just the way the dice rolled this year', or, ‘It's all just a crapshoot anyway; have a Merry Christmas'). No. Each responded with a defensive barrage of econospeak.
All four had been around the financial markets for decades. The question is, shouldn't that have given them an edge over the schoolboy when it came to ‘seat-of-the-pants' judgement? Seems the answer is no.
Finance psychologist Daniel Kahneman, whom I introduced back in chapter 1, has investigated this whole seat-of-the-pants judgement issue. He collaborated with researcher Gary Klein to investigate when skill and experience actually make a difference. They concluded that you need two basic conditions for acquiring a skill: an environment that is sufficiently consistent to be predictable, and plenty of practice.
Experienced sportspeople, surgeons, tradespeople and musicians are able to sum up situations very quickly. They've spent thousands of hours doing the same thing over and over. Their world is governed by a fair degree of consistency, which lends itself to skill development by repetition. They develop an ability to swing, cut, hit or pluck without thinking too hard about it.
But consistency is not a word that describes the financial markets. Today's market is different from yesterday's, which was different from the one the day before. And the reason it varies day to day is varying as well — no consistency, no pattern, no repetition. So it's not an environment that is conducive to skill development. The stock market is not an arena where time and practice convert into an ability to make reliable predictions.
It seems the only people who believe (or pretend) it is such an environment are ingenuous members of the public and a number of economic and market ‘experts' who are duping either themselves or the public.
BABSON'S BREAK
At the peak of the euphoric 1929 bull market, a single comment made by economist Roger Babson caused the US stock market to drop 3 per cent in a blink. On 5 September 1929 Babson was addressing a luncheon at the annual National Business Conference in Boston. It must have been a slow news day, because his comments were flashed across the country within minutes of being delivered.
Here are Babson's words: ‘Sooner or later a crash is coming which will take in the leading stocks and cause a decline of from 60 to 80 points in the Dow-Jones barometer.'12
The market reacted immediately. It dropped due to the prophecy of just one ‘expert'.a Some others were not happy with Babson's comments, so they presented their own expert willing to express the opposing view. At 2 pm that same day, high-profile Yale professor Irving Fisher announced publicly that Babson's comments were groundless. Now there were two experts at loggerheads. What a dilemma for followers of experts!
The fact is these guys were in the dark just as much as those reacting to their predictions. Which begs the question: why do we bother listening to stock market prophets at all?
Alfred Cowles, founder of the Cowles Commission for Research in Economics, came up with a great explanation for why we seek ‘expert' opinions, even when we're repeatedly reminded they're worthless. After extensive research, which failed to find any useful advice in numerous popular stock tipping and prediction sheets, Cowles had this to say:
Even if I did my negative surveys every five years, or others continued them when I'm gone, it wouldn't matter. People are still going to believe that somebody really knows. A world in which nobody really knows can be frightening.
Cowles is right: people are driven to know. And since they have absolutely no idea themselves, they look for someone who might.
The take-home message after combining the concepts of Kahneman and Cowles is that we have apparently confident experts delivering their message from a platform of self-delusion to an audience listening from a platform of blind, accepting ignorance. And neither truth nor reason need at any stage interfere with the message.
It reminds me of a comment made by Robert Rhea, a pioneer of Dow theory (which I'll explore in later chapters), about predicting stock prices:
Those who try to profit from the advance and decline of security prices are perplexed perhaps 90 percent of the time. And it seems that perplexity increases with experience … Unvarying cocksureness on the part of traders or investors is a badge of incompetence. There is, nevertheless, a time and a place for certainty where the market is concerned, but such times and places are few and far between.13
I agree with Rhea. And I would add that those times of (near) certainty are roaring bull and gut-wrenching bear markets. But even then not everyone sees these situations for what they are. They get caught up in the mood of the moment and fail to recognise how polarised the market is at the time.
It's interesting to see what Charles Dow thought of those claiming to know where the stock market would be next week or next month. Here are Dow's words from a Wall Street Journal editorial of 20 November 1901:
People who trade in stocks can set down as a fundamental proposition the fact that any man who claims to know what the market is going to do any more than to say that he thinks this or that will occur as a result of certain specified conditions is unworthy of trust as a broker.
And if you think I'm being a bit harsh, I've barely warmed up. Let me share with you the story of Evangeline Adams.
EVANGELINE ADAMS
Evangeline Adams was a celebrity astrologer. Her fame peaked just prior to the spectacular 1929 Crash. Her specialty was predicting where the market was heading. Not surprisingly, making bullish calls in a bullish market was serving her well at the time. That was until October 1929, when the stock market imploded — and with it her reputation.
The Crash and its aftermath remains the most shocking stock market collapse investors have ever experienced. In just two trading days, 28 and 29 October, the Dow Jones Industrial Average collapsed by 23 per cent. It triggered a grinding bear market that, by July 1932, saw the Dow down a chilling 89 per cent from its September 1929 high. It sent thousands of banks to the wall, bankrupted countless businesses and investors, and triggered the worst depression in American history. Of course, as it always does, the stock market eventually recovered, but it was 25 years before the Dow regained the dizzying heights of its pre-Crash peak.
Let's wind the clock back to the first half of 1929, the period just before the Crash. There was a carnival atmosphere in Wall Street. The Dow Jones was up threefold from the start of the decade. Making money in the stock market had been easy — just own stocks, any stocks. But some people were beginning to feel uneasy. They knew the market couldn't climb at this rate indefinitely. The question in their minds was, when to sell? People were looking for someone who could deliver the answer.
Enter Evangeline Adams — a national celebrity, a superstar of prediction, someone people could look to for guidance.
Adams wasn't a newcomer to the game of prediction. By 1929 she was already 70 years old and had been reading stars, palms and tarot cards for years. In 1914 she had been placed on trial for practising astrology, widely considered a questionable activity. She was acquitted after winning over the judge by delivering an accurate character description of his son based purely on his birth date.
But it was the years immediately leading up to 1929 that saw Adams' fame skyrocket, and with it her bank balance. At the peak of her fame she employed several assistants and stenographers to generate her monthly stock market forecasting newsletter. She typically received about 4000 letters a day from fans and followers. And from her rooms above Seventh Avenue's Carnegie Hall, she consulted to the rich and famous at $20 a sitting. This was a massive fee considering US factory workers were paid about 60 cents an hour at the time.
Among her many clients, two names stand out: Charles Schwab and John Pierpont Morgan.
By 1929 Schwab was a battle-hardened 67-year-old steel magnate. He'd experienced a long and successful career, first at Carnegie Steel and later at Bethlehem Steel. At the tender age of 35 he'd been appointed president of Andrew Carnegie's steel production powerhouse, and in 1901 he was instrumental in rolling Carnegie Steel into the newly created US Steel. Unfortunately, his capacity as a deal-maker was more than matched by his capacity to spend. Down to his last millions in 1929, Schwab was on his final roll of the dice. He threw what remained of his once-great fortune into the stock market, a gamble he was about to lose.
Evangeline's other high-profile client, J.P. Morgan, was a real surprise. Morgan died in 1913, but during the course of his career it's said he consulted with Adams, and there are claims he asked her for stock market predictions. That's possible, but it's difficult to understand given the hard-nosed financier that Morgan was. His credentials were even more impressive than Schwab's. While Schwab was a deal-maker, Morgan was that and much more. He was, without peer, the most powerful and highly respected financier Wall Street had ever produced — a financier's financier.
Is it plausible that ‘Jupiter', the supreme god of finance, was seeking financial direction from the heavens? And, for all her fame, what was Evangeline's track record?
On the evening of 2 September 1929, just weeks before the Crash, New York radio station WJZ broadcast a prediction made earlier that day by Evangeline. She'd told a WJZ reporter that ‘the Dow-Jones could climb to Heaven'. The fact was it was nearly there already. The Dow peaked the next day, 3 September, then commenced its now famous descent. By 24 October the market had fallen by 20 per cent from the time of Evangeline's prediction. Strike one against Evangeline.
But as market sentiment changed, Evangeline switched her call.
By the time the first of the big single-day corrections hit on 24 October, she'd done a complete about-face and was predicting a crash.
Black Thursday, 24 October 1929, gave investors their first taste of the fury that would be remembered as the 1929 Crash. The highlight of that day looked to be the visit to the exchange by Winston Churchill, who had recently lost his position as Britain's Chancellor of the Exchequer. But Churchill's arrival was overshadowed by the frenzy of activity occurring on the trading floor. Trade started fast and furious from the opening bell. Selling pressure dominated. By lunchtime the market had plunged by over 10 per cent on heavy trading volume. And, while the afternoon saw the market steady and even regain much of its earlier losses, the bear had been unleashed.
The number of shares traded for the day was nearly 12.9 million, a staggering 4.6 million higher than the previous record. Paper profits built on margin were lost in an avalanche of margin calls. Nerves were frayed. The last remaining shreds of confidence had been severed. Fear had become endemic.
So it was in Evangeline's office that her clients congregated that Thursday evening. They all sought direction: Where was the market heading? Should they sell? Should they hang on?
What Evangeline told her clients that night was a classic case of the pied piper leading her followers over the edge of the cliff. On the eve of the most horrific stock market rout the world has experienced, she advised her clients that the conjunction and interrelation of certain planets were creating ‘spheres of influence over susceptible groups, who in turn will continue to influence the market'.
She went on to say that the market would recover strongly over the next two trading days. But it was advice she wasn't prepared to take herself — her own stock portfolio was haemorrhaging. The next morning, worried about sustaining further loss, she telephoned her broker and told him to sell everything. Strike two against Evangeline.
Evangeline's third strike came when the market hit rock bottom in 1932, having fallen 89 per cent from its 1929 peak. But her opportunity to redeem her poor market record was over. She died only months later. Her story of ill-timed advice explains why you never see a newspaper headline that reads ‘Psychic Wins Lottery'.
In November 2012 stock markets around the world were celebrating a five-year anniversary — five years since markets were at their pre-GFC 2007 peak. To mark Australia's five-year anniversary, the TV news aired an interview recorded five years earlier on the very day Australia's stock market reached its zenith. The interview was with a high-profile stockbroker, but it might as well have been with Evangeline Adams.
How did the stockbroker go? Did he foresee the imminent market decline? No, he didn't. In fact his commentary didn't contain a hint of caution. Phrases such as ‘strong market momentum', ‘high earnings' and ‘good underlying value' spilled freely from his lips.
Remember the words I used at the start of this chapter: ‘Everything I have stated so far regarding our inability to predict applies to the stock market.'
JESSE LIVERMORE
I've already mentioned Jesse Livermore's name twice, so it's time I formally introduced him. Many recognise him as the greatest stock trader who has ever lived. And by trader I mean one who aims to profit from the short to medium movements in stock market prices rather than the long-term returns an investor expects by owning stocks for longer periods.
Livermore was born on 26 July 1877 in Shrewsbury, Massachusetts. His father was a poor farmer, the antithesis of what Jesse was to become. Jesse was a bright boy, excelling in mathematics at school.b Yet his father pulled him out of class at age 14, handed him a pair of overalls and announced it was time he started working for his keep.
Jesse's mother didn't want her son to spend his life eking out an existence from the New England soil. So, with her blessing and five dollars in his pocket, Jesse set off for Boston. At the tender age of 14 he found himself a job at stockbroking firm Paine Webber posting stock quotes on a chalkboard. The stock market was a natural home for Jesse, a medium where he could express his aptitude with numbers. He searched for meaning in the stock prices he was posting on the board. He made notes in a pocket book and developed theories on how to beat the market. Despite his youth, he started frequenting ‘bucket shops' to test his ideas using the cash he'd earned from his job.
Bucket shops were nothing more than betting shops where patrons bet on stock price movements rather than racehorses. Physical stocks were not exchanged; rather, movements in stock prices formed the basis of the bet. The betting stake was made on margin against the house. Jesse became so successful he was progressively banned from all the bucket shops in Boston. He earned the nickname ‘Boy Plunger'.
It was inevitable that Livermore would end up on Wall Street. Ultimately he carved out a career in stock trading that spanned four decades. He shorted the 1907 Panic, netting $3 million in trading profits. He did it again during the chaos of the 1929 Crash, netting $100 million. He became a household name. The press loved him. Time described him as the most fabulous living US stock trader.
Livermore's life wasn't always characterised by financial success, however. He filed for bankruptcy in 1934, for example, and it wasn't the first time that trading in stocks had wiped him out. He was broke three times by the age of 30, and he suffered from chronic depression. These demons ultimately caused him to take his own life. On 28 November 1940 he walked into the cloakroom of the Sherry Netherland Hotel on Fifth Avenue, New York, placed a .32-calibre Colt automatic pistol behind his right ear and pulled the trigger.c
Was it skill or luck that delivered Livermore a millionaire's life? We'll never know. But one thing is for sure: he was an extremely intelligent man who devoted his life to studying the stock market. Draw your own conclusion.
History has thrown up some brilliant and insightful investors and traders. De la Vega, Dow, Livermore, Graham, Buffett — they've each brought their own trading and investing methods to the market. On the surface these methods appear to be totally different. Yet when you dig deeper it becomes apparent these men possessed three common characteristics: intelligence, insight and intensity of application.
Given that Livermore profited from shorting the 1907 Panic and the 1929 Crash, did he possess an ability to forecast the market? Not according to Livermore himself; he no more had a crystal ball than the rest of us. What he did was take a view — a view based on how he expected people to react to news. The following are his words:
Speculation is nothing more than anticipating coming movements. In order to anticipate correctly, one must have a definite basis for anticipation, but one has to be careful because people are often not predictable — they are full of emotion — and the market is made up of people.14
So Livermore undertook his trades with both feet placed firmly in the present. He waited for the first signs that his view might be played out before acting. In his words: ‘Don't back your judgment until the action of the market itself confirms your opinion.'15
Livermore regularly got it wrong. But he (usually) got out of his position quickly before too much damage was done. Despite his being one of the most revered traders of his time, and still for many people today, these are not the actions of someone who could reliably forecast the future direction of the stock market. Livermore was one of the world's most famous traders, but a trader who didn't claim an ability to predict the future and didn't use charts!
I'd like to finish this chapter with a great quote from Warren Buffett, the world's most successful investor: ‘Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.'
Chapter summary
- The stock market is no different from any other forum. Like all others, it cannot be accurately predicted.
- The power of prediction eludes even seasoned stock market participants because two basic conditions for acquiring a skill can't be met: the market isn't sufficiently consistent, and therefore it doesn't allow for practice.
- There always has been, and likely will continue to be, no shortage of participants who claim an ability to predict.
- Neither the world's greatest trader nor the world's greatest investor have claimed a capacity to predict the movements of the stock market.