In the latest issue of our Motley Fool Stock Advisor newsletter, I ran across a delightful tidbit -- it seems that according to the research of Cal Tech professor David Leinweber, the "single best predictor of the S&P 500's performance" that he found was the production of butter in Bangladesh.
I looked for more details, of course, and learned that between 1983 and 1993, "when butter production was up 1%, the S&P 500 was up 2% the next year. Conversely, if butter production was down 10%, you could predict the S&P 500 would be down 20%."
This info was presented in a 1998 Money magazine article by Laura Washington that addressed backtesting. Washington explained correctly why we should be wary of backtesting when we encounter it. It involves taking a current strategy and applying it to past data, resulting in some "what-if" results. An example will make this clearer. Imagine, for example, that I notice that the number of potholes on my street each January correlates very well to how the stock market will perform. I may then try to capitalize on this, by perhaps launching a mutual fund that invests in various securities depending on the smoothness or roughness of my street. I may advertise my fund by showing how my pothole prediction method got it right in 19 of the past 20 years.
That could impress you and others enough to invest, but should it? No, not really. Because it's all based in the past. It remains to be seen whether my potholes will predict anything correctly in the coming years. For all we know, my city will change its pothole policies in the coming year, wreaking havoc on my system.
When you see a new investing approach that showcases how well you would have done before it existed, be careful. Remember that if the results weren't so rosy, you wouldn't be told about them. Looking back, it's easy to be choosy with the details we focus on and share.
In perspective
Back to our Motley Fool Stock Advisor newsletter (try it for free for 30 days, during which you can access all past issues and read about every recommendation). In it, Rich Greifner urged readers to avoid trying to time the market. I've done the same thing in many past articles.
So when you hear about this or that terrific stock market predictor, just roll your eyes. You may hear, for example, about the Super Bowl effect, where a victory by an old NFC team suggests a coming rise in stock prices, while an AFC victory predicts a market downturn. You may hear about the so-called "January effect," too, where smaller companies have tended to do well in January. But note that as more people become aware of that effect and buy into small companies in anticipation, whatever effect might have existed will be diminished or eliminated.
A promising predictor
If you want some more promising market predictions -- forward-looking ones -- I invite you to explore our new world of CAPS, a community of tens of thousands of investors predicting the movement of thousands of stocks. Instead of relying on backtesting, you can find some participants with very strong track records (we highlight these folks for you) and can then follow their new predictions -- testing them going forward.
For example, one of our top-rated participants is TMFKmoney, and some of the stocks on which he's bullish include VMware (NYSE:VMW), Sun Microsystems (NASDAQ:JAVA) IBM (NYSE:IBM), and Google (NASDAQ:GOOG). Will he be more accurate than Bangladeshi butter going forward? Stay tuned!
