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The Value of Predictions, or Where'd All This Rain Come From?

Anyone who has been my client for long has heard from me on many occasions with
negatie comments about mar!et forecasts" #ow,$ hae decided to say at once all of the
bad things $ can thin! of about %redictions"
&The '(%ected Value of a Forecast ) Value ofCorrect Forecast ( Probability of *eing
Correct
The motiation for trying to guess the direction of stoc!s or bonds is easy to understand"
+bserers hae for years noted the wide %rice swings, calculated the alue of a dollar
inested at the bottoms and disinested at the to%s and com%ared the result against the
alue of a dollar inested under a ,buy-and-holdP
.
Pstrategy" The difference is always
tem%tingly large"
The %roblem, howeer, comes from the fact that none of the forecaster's attem%ts to
ca%ture the swings hae any alue unless his or her %redictions are right"
&*ut $t's /ard to be Right
$ agree with 0ohn 1enneth 2albraith" /e said ,We hae two classes of forecasters3 Those
who don't !now -- and those who don't !now they don't !now". $f it was easy to %redict the
future, it would be easier to attain e(cellent inestment results -- then maybe eeryone could
hae aboe-aerage %erformance"
&*eing Right With Aerage Consistency 4oesn't /el%
5et's face it3 most of us hae roughly the same ability to %redict the future" And the trouble
is that being right as often as the aerage forecaster won't %roduce su%erior results"
'ery inestor wants results which are aboeaerage" $n the institutional world,
relatie %erformance is the /oly 2rail" 'enelsewhere, the ob6ectie is to be the first
to see the future -- and ta!e the a%%ro%riate route to %rofit" $t obiously doesn't hel% in
these %ursuits to be right only as often as others are"
7 +a!tree Ca%ital 8anagement, 5"P"
All Rights Resered
&An Aerage Forecast 4oesn't /el% 'en $f $t's Correct
*eing 9right9 doesn't lead to su%erior %erformance if the consensus forecast is also right"
For e(am%le, if the consensus forecast for real 2#P growth is :;, then stoc! %rices will
come to reflect that e(%ectation" $f youthen conclude that 2#P will grow at :; and your
e(%ectation of ra%id growth motiates you to buy stoc!s, the stoc!s you buy will be at %rices
which already antici%ate such growth" $f actual 2#P growth at :; is subse<uently
announced, stoc! %rices %robably will not 6um% -- because their reaction to :; growth too!
%lace when the consensus forecast was arried at" $nstead, the best guess is that you will
earn the normal ris!-ad6usted return for e<uities oer your holding %eriod" *ottom line3
correct forecasts do not necessarily translate into su%erior inestment results"
&Aboe-Aerage Profits Come From Correctly Forecasting '(treme 'ents
At least twenty-fie years ago, it was notedthat stoc! %rice moements were highly
correlated with changes in earnings" =o %eo%le concluded that accurate forecasts of earnings
were the !ey to ma!ing money in stoc!s"
$t has since been reali>ed, howeer, that it's not earnings changes that cause stoc! %rice
changes, but earnings changes which come as a sur%rise" 5oo! in the news%a%er" =ome
days, a com%any announces a doubling of earnings and its stoc! %rice 6um%s" +ther
earnings doublings don't een causea ri%%le -- or they %rom%t a decline" The !ey <uestion
is not 9What was the change?9 but rather 9Wasit antici%ated?9 Was the change accurately
%redicted by the consensus and thus factored into the stoc! %rice? $f so, the announcement
should cause little reaction" $f not, the announcement should cause the stoc! %rice to rise if
the sur%rise is %leasant or fall if it is not"
This raises an im%ortant Catch ??" 'eryone's forecasts are, on aerage, consensus
forecasts" $f your %rediction is consensus too, it won't %roduce aboe-aerage
%erformance een if it@s right" =u%erior %erformance comes from &accurate
nonconsensus&forecasts" *ut because most forecastersaren't terrible, the actual results
fall near the consensus most of the time-- and non-consensus forecasts are usually
wrong" The %ayoff table in terms of%erformance loo!s li!e this3
Forecast
Consensus #on-Consensus
Aes Aerage Aboe Aerage
Accurate?
#o Aerage *elow Aerage
7 +a!tree Ca%ital 8anagement, 5"P"
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The %roblem is that e(traordinary %erformance comes only from correct nonconsensus
forecasts, but &non-consensus forecasts are hard to ma!e, hard to ma!e
correctly and hard to act on&"
When interest rates stood at B;in CDEB, most %eo%le thought they'd stay there" The interest
rate bears %redicted D;, and the bulls %redicted E;" 8ost ofthe time, rates would hae
been in that range, and no one would hae made much money"
The big %rofits went to those who %redicted C:; long bond yields" *ut where were those
%eo%le? '(treme %redictions are rarely right, butthey're the ones that ma!e you big
money"
&8ost Forecasts are '(tra%olations
The fact is, most forecasters %redict a future<uite li!e the recent %ast" +ne reason is that
things generally continue as they hae beenF ma6or changes don't occur ery often" Another
is that most %eo%le don't do 9>ero-based9 forecasting, but start with the current obseration
or normal range and then add or subtract a bit as they thin! isa%%ro%riate" 5astly, real 9sea
changes9 are e(tremely difficult to foretell"
That's why some of the best-remembered forecasts are the ones that e(tra%olated current
conditions or trends but werewrong" *usiness Wee! may neer lie down 9The 4eath of
'<uities9 and 9The 4eath of *onds"9 At the mid-CDDG lows, the %ress suggested that no
one would eer buy a high yield bond again" $n CDBD, nobody thought the Cowboys would
eer win without Tom 5andry, or that the 5a!ersor HDers would eer lose" =i( years ago,
the growth of both coasts' economies was considered assured, and the Rustbelt's suffering
was e(%ected to continue foreer" +nly two years ago, 2eorge *ush was a shoe-in"
And that brings me to my subtitle3 Where'd All This Rain Come From? The motiation for
this memo came as $ considered the e(traordinary amount of %reci%itation the West has
e(%erienced this year -- and news%a%er articles of a cou%le ofmonths ago" According to
the articles, the rings on old trees suggested that fifty year droughts might be the norm and
the fie year drought to date 6ust the beginning"
#o one %redicted the drought before it began -- when such a forecast might hae hel%ed"
*ut 6ust as it may hae been about to end, the %ossibility of its long-term continuation was
uneiled"
7 +a!tree Ca%ital 8anagement, 5"P"
All Rights Resered
&Forecasters are &sually 8ost Wrong at the '(tremes
$t's at 6ust such times --- such inflection %oints -- when accurate forecasts of change
would be the most aluable butare the hardest to ma!e"
Ta!e high yield bonds, for instance" $n CDBD and CDDG they absorbed a continual beating as
a series of negatie deelo%ments came together" There was the recession, the failure of a
number of the leeraged buyouts of the CDBGs, enactment of e(cessiely stringent
regulation and the colla%se of 4re(el *urnham, Columbia =aings and '(ecutie 5ife" All
of this was tied together -- and accentuated -- by lots of oerly negatie %ublicity"
'ach deelo%ment was another dri% of 9Chinese water torture"9 'ach one %ut an end
to some inestor's ability to remain o%timistic" And so each one eliminated a %otential
buyer, created a seller and moed %rices lower"
And after all, what is a mar!et bottom? $t'sthat moment when the last holder who will
become a seller actually does so -- and thus the moment when %rices hit leels that will
%roe to hae been the lows" From that %ointon, with no one left to turn negatie, a few
%ieces of good news or the arrial of a few buyers with belief in alues are enough to turn
a mar!et"
=o you can see that the crescendo of negatiism, the lowest %rices and the greatest
difficulty in %redicting a riseall occur simultaneously" #o wonder it's hard to %rofit
from forecasting"
&'(treme Forecasts are /ard to *eliee and Act +n
5et's say the aerage inestor was a%%roached in +ctober CDDG by someone who had
enough imagination and courage Ibecause that'swhat was neededJ to ma!e a %ositie case
for high yield bonds" Would the inestor hae belieed and bought? Probably not"
Potentially-%rofitable non-consensus forecasts are ery hard to beliee and act on for the
sim%le reason that they are sofar from conentional wisdom" $f a forecast was totally
logical and easily acce%ted, then it would bethe consensus forecast Iand its %rofit %otential
would be much lessJ"
=o if someone told you the &"=" auto ma!ers' share of domestic mar!et was going bac! to
CGG; in fie years, that would be a forecast with enormous im%lications for %rofit" *ut could
you %ossibly beliee it? Could you act on it?
The more a %rediction of the future differs fromthe %resent, ICJ the more li!ely it is to
dierge from the consensus forecast, I?J the greater the %rofit would be if it's right, and
IKJ the harder it will be to beliee and act on it"
7 +a!tree Ca%ital 8anagement, 5"P"
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&Aou /ae to *e Right About Timing Too
#ot only must a %rofitable forecast hae the eent or direction right, but it must be
correct as too timing as well"
5et's say you acce%ted the forecast that the *ig Three would come to again own CGG; of
the &"=" mar!et, and you bought the stoc!s in res%onse" What if a year later their share was
lower Iand their stoc!s tooJ? Could you continue to hold out for the long term, or would
your resole wea!en? What if their shares Iand stoc!sJ were unchanged fie years later?
Wouldn't you gie u%? And wouldn't that be 6ust in time to see the %rediction come true?
$n %o!er, 9scared money neer wins"9 $n inesting, it's hard to hold fast to an im%robable,
non-consensus forecast and do the right thingLes%ecially if the cloc! is telling you the
forecast is off base" As $ was told years ago, 9being too far ahead of your time is
indistinguishable from being wrong"9
&$ncorrect Forecasts Can Cost Aou 8oney
As you !now, we run our %ortfolios without reference to what we thin! the broad mar!ets
will do" An obserer might thin! such behaior e(%oses us unduly to the fluctuations of the
mar!ets, and that to %rotect our clients weshould actiely go in and out of the mar!ets
based on what we thin! will ha%%en"
*ut remember, that will wor! only if our forecasts are right Iand right more often than the
consensus is rightJ" $ would argue that because forecasting is uncertain, it's safer notto try"
For e(am%le, %eo%le hold e<uities because theyfind %ros%ectie long-term e<uity returns
attractie" The aerage annual return on e<uities from CD?M to CDBE was D"HH;" *ut if you
had gone to cash and missed the best :G of those EHH months, you would hae missed all of
the return" This tells me that attem%ts at mar!et timing are a source of ris!, not
%rotection"
$t would be nice in antici%ation of subse<uent %erformance to be able to ary the amount
inested, but $ thin! it's 6ust too ris!y to try"
&$t Costs 8oney to 8a!e Forecasts
As suggested aboe, the best thing might 6ust be to settle for aerage long-term
%erformance in mar!ets thatare hard to %redict"
'fficient mar!eteers thin! stoc! mar!et forecasts are about as good as coin tosses" $f you're
right half the time without bias, your forecasts won't hel% or hurt ersus buy-and-hold" *ut
7 +a!tree Ca%ital 8anagement, 5"P"
All Rights Resered
forecasts are im%lemented through transactions which cost money" $f you're right half
the time and s%end money to try, your %erformance will fall further below buy-andhold results
the more trading you do"
&Few Peo%le Reisit Their Forecasts
We always read 9$ thin! the stoc! mar!et's going to go u%"9 We neer read 9$ thin! the
stoc! mar!et's going to go u%, Iand B out of mylast KG %redictions were rightJ9 or 9$
thin! the stoc! mar!et's going to go u% Iand by the way $ said the same thing last year
and was wrongJ"9 Can you imagine deciding which baseball %layers to hire without
!nowing their batting aerages? When did you eer see a mar!et forecaster's trac!
record?
&8ost Forecasts 4on't Allow for Alternatie +utcomes
$ imagine that for most money managers, the %rocess goes li!e this3 9$ %redict the
economy will do A" $f A ha%%ens, interest rates should do *" Withinterest rates of
*, the stoc! mar!et should do C" &nder thatenironment, the best %erforming sector
should be 4, and stoc! ' should rise the most"9 The %ortfolio e(%ected to do best
under that scenario is then assembled"
*ut how li!ely is ' anyway? Remember that ' is conditioned on A, *, C and 4"
*eing right two-thirds of time would be a great accom%lishment in the world of
forecasting" *ut if each of the fie %redictions has a ME; chance of being right, then
there is a CK; %robability thatall will be correct and the %ortfolio will %erform as
e(%ected"
And what if some other scenario unfolds? /ow will the %ortfolio do? /ow do the
forecasterNinestors ma!e allowances in their %ortfolios for the li!elihood that their
%redictions will %roe incorrect?
&5astly, As! Aourself 9Why 8e?9
*y this $ mean 9if someone has made a %otentially aluable forecast with a high
%robability of being right, why isit being shared with you?9
Thin! how %rofitable a correct mar!et forecast could be" With ery little ca%ital, a good
forecaster could ma!e many times more in the futures mar!et than in salary from an
em%loyer" +!ay, let's say he li!es to wor! for other %eo%le -- than why does his
em%loyer gie his forecasts away rather than sell them? 8aybe the thing to as!
yourself is whether you would write out a chec! to buy the forecast you're considering
acting on"
7 +a!tree Ca%ital 8anagement, 5"P"
All Rights Resered
2roucho 8ar( said 9$ wouldn't 6oin any club that would hae me as a member"9
Another formulation may be 9$ would neer act on any forecast that someone would
share with me"9 $'m not saying that no one has aboe-aerage forecasting ability"
Rather, 'as one &niersity of Chicago %rofessor wrote in a %a%er years ago, such
forecasters are more li!ely to be sunning themseles in =aint Tro%e> than going around
entreating %eo%le to borrow their forecasts"
O O O
There is a bottom line for us on the sub6ect of %redictions regarding macro-scale
eents and widely-followed mar!ets aboutwhich information is rather eenly
disseminated Iso-called efficient mar!etsJ" $n sum, we feel that3
most forecasters hae aerage ability
consensus forecasts aren't hel%ful
correct non-consensus forecasts are %otentially ery %rofitable but are also hard
to ma!e consistently and hardto bring yourself to act on
forecasts cost money to im%lement and can be a source of ris! rather than
return
The im%lications for us are clear" We will continue to eschew %ortfolio management
based on forecasts of mar!et trends, about which we thin! neither we nor anyone else
!nows much"
$nstead, we will continue to try to 9!now the !nowable9 -- that is, to wor! in mar!ets
which are the sub6ect of biases, in which non-economic motiations hold sway, and in
which it is %ossible to obtain an adantage through hard wor! and su%erior insight" We
will wor! to !now eerything we can about a small number of thingsLrather than a
little bit about eerything"
Conertible securities, high yield bonds and distressed com%any debt are all mar!ets in
which mar!et inefficiencies gie rise to unusual o%%ortunities in terms of return and ris!"
We will continue to e(%loit these o%%ortunities in a manner which is ris!-aerse and
non-reliant on macro-forecasts"
February C:, CDDK
" " " P%redictionsQ ought to sere but for winter tal!s by the fireside"
=ir Francis *acon
7 +a!tree Ca%ital 8anagement, 5"P"
All Rights Resered
5egal $nformation and 4isclosures
This memorandum e(%resses the iews of the author as of the date indicated and such iews
are
sub6ect to change without notice" +a!tree has no duty or obligation to u%date the information
contained herein" Further, +a!tree ma!es no re%resentation, and it should not be assumed, that
%ast inestment %erformance is an indication of future results" 8oreoer, whereer there is the
%otential for %rofit there is also the %ossibility of loss"
This memorandum is being made aailable for educational %ur%oses only and should not be
used
for any other %ur%ose" The information contained herein does not constitute and should not be
construed as an offering of adisory serices or an offer to sell or solicitation to buy any
securities or related financial instruments in any 6urisdiction" Certain information contained
herein concerning economic trends and %erformance is based on or deried from information
%roided by inde%endent third-%arty sources" +a!tree Ca%ital 8anagement, 5"P" I,+a!tree.J
beliees that the sources from which such information has been obtained are reliableF howeer,
it
cannot guarantee the accuracy of such information and has not inde%endently erified the
accuracy or com%leteness of suchinformation or the assum%tionson which such information is
based"
This memorandum, including the information contained herein, may not be co%ied, re%roduced,
re%ublished, or %osted in whole or in %art, inany form without the %rior written consent of
+a!tree"

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