Shots heard ’round the world

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  By Guest Blogger Doug Rowat

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Business headlines like these pop up in our newsfeeds every day:

Does one correct call make a good forecaster?

Source: MarketWatch

The implication is obvious: a single accurate past call makes an analyst’s new predictions more credible. At first glance, such headlines seem persuasive, but be wary, they shouldn’t be.

One correct forecast doesn’t reveal any true forecasting talent. While certainly these traders and analysts should be congratulated for their past accuracy, what they’ve achieved is, after all, only one right prediction. What would be more useful is to know how consistently they’ve been accurate over the long haul. In other words, a track record. But rarely, if ever, is such information available.

One of the most famous predictions in Wall Street history was bank analyst Meredith Whitney declaring in 2007 that Citigroup would cut its dividend. While her call on Citigroup and other US banks just prior to the financial crisis propelled her to fame, her track record since has been more uneven, including her bold, but inaccurate, 2010 forecast that there would be a wave of US municipal bond defaults.

But, of course, it’s the bold predictions that garner an analyst the most media attention. And, if you swing for the fences and are fortunate enough to connect, Wall Street will immortalize you, even if, overall, you turn out to be quite average.

As we celebrate this week the 50th anniversary of Hank Aaron’s 715th home run, which broke Babe Ruth’s all-time record, it’s fitting to suggest that most Wall Street analysts are less Hank Aaron and more Bobby Thomson. Both hit two of the most famous homeruns in baseball history (Thomson for his Shot Heard ‘Round the World against the Brooklyn Dodgers in 1951 and Aaron for that 715th dinger); however, only Aaron could actually be called a great hitter. (Bobby Thomson had a lifetime 0.270 batting average with only 264 career homeruns.)

But if you swing hard and connect once, the media will love you forever. Meredith Whitney still grabs headlines. Just this week she received plenty of attention for suggesting that US house prices could correct by 20%.

And this is the go-big-or-go-home pattern of Wall Street forecasting. Social scientist Dan Ariely refers to it as “using extremity to enhance identity”. Ariely’s focus is on those trying to secure their place within a social group or establish themselves on social media, but the concept can be applied to Wall Street pundits:

They need to make a splash… Extreme opinions are a key to being noticed; to showing loyalty and commitment; and to climbing the real and imaginary social ladders within a group.

Forecasting, like opinions on social media, can also quickly evolve into a “process of escalating extremity”. (There’s irony here because Ariely himself has been accused of arriving at more and more newsworthy research results based on manipulated data—I told you to be wary of information that’s presented to you.)

However, escalating extremity definitely occurs in finance. This is why we often see not just calls for simple 10% market corrections like in the example above, but for 40%, 50% or even 70% market pullbacks. This, for example, hit our newsfeeds just a couple of weeks ago:

Mission accomplished: this 32-year market vet probably got the media attention they wanted

Source: Business Insider

A 70% market decline? Recall that the financial crisis, a once-in-a-generation event, which saw Lehman Brothers and Bear Stearns go belly up, resulted in only a 57% decline for the S&P 500. A 70% market decline would mark the worst bear market in 75 years and would also be roughly DOUBLE the decline of an average bear market. Interestingly, this analyst’s dire market forecast also manages to be both vague (“in the years ahead”) and yet still urgent (“imminently”).

But what will happen when this analyst is almost certainly wrong? A mea culpa? A follow up from the media?

No, the media will simply move on to the next analyst who’s willing to swing for the fences.

Even if that analyst’s lifetime track record looks more like Bobby Thomson’s and less like Hank Aaron’s.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.