Does Stock Forecasting Work?

Posted on October 6, 2011 at 9:46 AM PST by

Remember Yahoo, Gordo. It’s like Abracadabra.

In the time travel movie Frequency, this Yahoo stock tip was passed through time to the six-year-old Gordo via a mysterious interplay of a ham radio and the aurora borealis. This small bit of incomprehensible information was not only retained by Gordo, but later, when he grew up and became a stock trader, it resulted in him not only being fat, but quite happy as well.

The power of knowing the future is profound. Just imagine, for a moment, if you were given the privilege of seeing stock market results one year from today. A resourceful individual could easily parlay that knowledge into profound wealth. It is no wonder that economists, stock traders, fund managers, and financial advisers alike are desperately trying to find a way to peak around the corner of time to anticipate what the markets will do.

Forecasting markets is not for the feint of heart. Take, for instance, the recent housing bust and subsequent recession. Top economists and investors alike failed to see it coming. Ben Bernanke, the Federal Reserve chairman, testified at the Financial Crisis Inquiry Commission (FCIC) that, “We knew all those numbers, of course, but a lot of smart people, including people like Paul Volcker and others, . . . got it wrong. It is just another example of how difficult it is to predict.” Furthermore, Alan Greenspan commented, “We all misjudged the risks involved. Everybody missed it—academia, the Federal Reserve, all the regulators.”

It was not only the economists that failed to see the crisis coming, but leading investors as well. Take George Soros as an example. He became one of the world’s richest people by predicting the UK currency collapse and betting accordingly, and yet he took an ill-fated stake in Lehman Brothers just before the bank failed in 2008. Likewise, Warren Buffett, the Oracle of Omaha, lost billions in the downturn and testified before the FCIC that “no one saw the housing bubble.”

But just when you think that such foresight is outside the reach of common man, some prognosticator emerges with a specific contrarian view and then with eerie accuracy hits the nail on the head. It’s as though he found his own flux capacitor-equipped DeLorean and sailed from the future to the present with otherworldly insight.

Take for instance, the small group of esteemed economists and financial managers that called the housing crisis. There is Dean Baker, the co-director of the Center for Economic and Policy Research in Washington, D.C., who in the August 4, 2004 issue of The Nation gave a detailed warning concerning the coming housing crisis in an article called Bush’s House of Cards. His predictions were five years early and largely ignored. Then there is Med Jones, the president of the International Institute of Management (IIM), a U.S.-based research and education organization. Although Jones is less known, he turned out to be the most accurate in predicting many of the downturn’s details.

Nouriel Roubini, an NYU economics professor known as Dr. Doom for his wild and dire predictions, became a media darling because of his accurate foretelling of the crisis. More bearish still is Peter Schiff, who now famously predicted the housing collapse in nationally televised debates. Although ridiculed by experts, he showed great courage, and his detailed analysis proved right in the end.

It is these types of expert forecasts that make investors seek the next accurate prediction. Think of how you might have managed your portfolio differently if you had only listened to these warnings before the housing crash. Furthermore, today, there are forecasters out there who are nailing their predictions right before our eyes. A year from now, many will lament the fact that their laser-sharp predictions were carelessly ignored.

So how does an investor know which forecasts to follow and which to ignore? The first thought that comes to mind is to follow the predictions of those that have gotten it right in the past. This method, however, proves to be ill fated. Take, for instance, the four gurus that called the housing crisis. Since that time, each of these prognosticators has supplied a long list of additional predictions. Sadly, the overwhelming majority of them have been tragically afield. In a famous prediction from 2002, Peter Schiff asserted that the Nasdaq would hit 500 and that the Dow would crash to 4,000. If you had followed his advice, you would have lost your shirt.

Nouriel Roubini has made over 30 economic predictions since 2006, with 22 coming up wrong and seven still awaiting fulfillment. Well, at least he got one right—the housing crisis. Whereas Med Jones seems to have a better batting average, Dean Baker’s predictions are about 50/50.

In the end, stock forecasting seems to be a bit more Abracadabra than most investors would prefer. As much as we would like the aurora borealis or at least something or someone to whisper an accurate stock tip that would leave us fat and happy, we are left with the harsh reality that forecasters often flop.

With no real way of seeing around the corner of time, smart investors are left with the proven methods of global asset allocation, low-cost indexing, and disciplined rebalancing. This proven approach may not provide the wonders of time travel, but it does provide a nice bounty to the principled and disciplined—over the long haul.