1 Lesson the Market Needs to Get Through Its Thick Head

Remember last week's Federal Reserve meeting. Almost everyone on Wall Street had been expecting the Fed to begin paring back its stimulus package. Most were betting the $85 billion monthly bond-buying would be trimmed down to $75 billion, but they were wrong. The Fed didn't taper, and markets went wild. The Dow Jones Industrial Average (DJINDICES: ^DJI  ) shot up 200 points in a flash. Gold and Treasury yields both fell 5%, and oil jumped as well. Trillions of dollars in assets moved dramatically simply because of one announcement and one bad prediction.

Ben Bernanke, the Greek god of financial markets. Source: Federal Reserve.

In the aftermath, analysts backpedaled to explain why the Fed had not gone ahead with the stimulus and reassessed their predictions. Others blamed Chairman Ben Bernanke for not communicating his plan adequately. Almost no one on Wall Street, however, stepped back and looked at the big picture. There was no industrywide introspection following this huge gaffe, no attempt to see the forest for the trees; and there's a simple explanation for that.

Wall Street has an arrogance problem.

I don't mean arrogance as in they pay themselves too much, snub you at your high school reunion, or act rude to waitresses -- though that may all be true. I mean they are arrogant enough to believe they know the future. The response to the Fed's announcement was the worst example of this in a while, but we see evidence of this every day in the financial press. In fact, much of the financial industry is based on this pretense.

Precision vs. accuracy
In his 2012 book The Signal and the Noise, statistician Nate Silver, who correctly predicted the winner of all 50 states in the 2012 presidential election, explores the difference between precision and accuracy, two often-confused concepts in forecasting. In the run-up to the financial crisis, he notes that Moody's "AAA" ratings on mortgage-backed CDOs -- the ones that would implode the economy -- were based on calculations carried out to the second decimal place. The calculations were precise but incredibly inaccurate. Moody's underestimated the default risk by a factor of two hundred, says Silver. This problem continues to plague Wall Street today. Pundits mask often inaccurate predictions with precise figures. Headlines such as "Dow to hit 30,000" or "Dow Will Drop to 10,000" regularly dot financial news sites quoting well-known fund-managers and pundits with mostly poor reasoning to back up their argument. Below are a couple of my favorites:

"Dow Could Crash to 3,000 in 2013."

This CNBC article from September 2011 quotes economist Harry Dent as saying: "I think the stock crash started in late April. This is just the first wave down. ... I think the crash really starts sometime in early 2012." Dent went on to explain that his theory was based on an aging baby-boomer population and a deleveraging of U.S. private debt. Fast-forward two years and the Dow is up nearly 50% since then, and Dent couldn't have been more wrong about early 2012. That's when stocks really started gaining.

"David Tice: Gold Will Surge to $2,500 and the S&P 500 (SNPINDEX: ^GSPC  ) will plunge to 1,000."

A double whammy! Tice, a former chief portfolio strategist for Federated Investors, made this prediction in March 2012 with an 18-month price target. In another words, it expired last week. Tice explained, "We feel like we did in 1999 and 2007. During both of those periods, people were positive about credit being created, the central banks were easy, everyone was complacent, and we ended up having a big accident." Yet 18 months later, the S&P hovers around 1,700, while gold is near $1,300 an ounce.

These headlines may seem laughable now, but they were they were no joke at the time they were published, and similarly ridiculous predictions are just as common today.

The reason for this is simple: Easy answers are always appealing. And with smartphones, tablets and cable news all within arm's reach, we live in a short-attention-span world. Headlines like "Dow To Hit 20,000 by 2015" and other predictions catch eyeballs and drive page views, but they do investors a disservice. It's important to remember that future stock market values are based on future events, which are largely unknowable.

Prediction vs. analysis
As consumers of financial news, we want analysis, but what we often get are predictions. We want to buy good companies at low prices, and we're looking for information and insight to lead us to these stocks. With that analysis in hand, we then make a prediction -- i.e., x stock will go up because of y and z factors. Good predictions are based on analysis, but often Wall Street puts the cart before the horse, getting carried away with the prediction instead of analysis, putting precision ahead of accuracy. Price targets and the market's obsession with analyst ratings both lend themselves to this fallacy. Price targets are often wildly off the mark and have been derided as "marketing fluff" by some in the industry, but analysts simply adjust them in response to new developments. No one is paying attention to the analysis -- just the (often bad) prediction.

The noise and the signal
Financial news is noisy, and investors should be wary of reductive or simplistic statements about the stock market, ignoring pundits who offer broad predictions without evidence to back up their claim. Though we like to pretend we understand the market's every movement, there's often no clear reason. Stocks move with or without a cause.

In the case of last week's non-taper, there never was a signal. What started out as a few mumblings from regional Fed presidents snowballed into an assumption that metastasized into Wall Street gospel, but there was no clear evidence that the Fed would go ahead with the September taper in the first place. Chairman Ben Bernanke had always insisted that the decision would be data-driven, and given weak jobs reports over the past few months, the committee simply seemed to be responding to the data.

Predictions must be based on evidence; without it they're worthless. Recalling the 2012 election, that's why Nate Silver, who based his electoral model on polling data from each state, was so right, while the pundits, whose fleeting observations and gut feelings led them to declare the race "too close to call," were so wrong.

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