Albert Einstein was, by all accounts, a genius. But he was also an eccentric man who had trouble relating and engaging in conversations with the average person. He often wished to travel to heaven, where he reckoned he could have conversations with people who shared his intellect and could relate with him better.
One day, God granted Einstein his wish and provided him with a getaway from his earthly calvary.
Up there, in heaven, Einstein met a man. “So we can talk; what’s your IQ?” he asked the stranger. “It’s 180,” the man said. And Einstein was delighted. “Fantastic! I’ve got a new synthesis of quantum and gravitational theories, and I’d love to discuss it with you!” They conversed for days before Einstein went and met a second man. “So we can talk; what’s your IQ?” he asked the second man. And the gentleman responded, “It’s 140.” Einstein, still pleased, went ahead. “Fine... I’ve been pondering over the real meaning of Shakespeare’s alexandrines, and I’ve arrived at new interpretations that I’d like to share with you.” They sat down and chatted for hours. Tiring of that conversation, Einstein met a third man. “So we can talk; what’s your IQ?” he asked the stranger. “60,” the man replied. Einstein was taken aback. He was at a loss for words, as though he was back on earth again. Then, suddenly, it dawned on him, “What’s your S&P 500 forecast for this year?”
The financial sphere and its closet charlatans
The reader can guess that S&P 500 and this year are not the points of our little farce above. Instead of the S&P 500 forecast, other versions could have used the outcome for the market next month, inflation for the next two years, yields for the next ten years, GDP in the second quarter, or even if China is going to depose the U.S. as the global hegemon by the year 2030? Our point is much broader. It has to do with the problem of predictability in social matters.
But let’s discuss the subject from the narrow standpoint of the S&P 500 index, which interests many investors the most. The path of the index — said differently, the returns on the broad, large-cap market portfolio — is in effect a social matter. How? A dull but necessary dissection of the (non-pertinent) question “what’s your S&P 500 forecast this year” will make it evident.
Asking for an S&P 500 forecast this year means asking about:
the market value of five hundred large American corporations on the last trading day of the year.
It means asking about:
the value attributed to the equity of five hundred large American corporations by stock market participants through transacting their shares on the last trading day of the year.
Each of the italic phrases that precede is tantamount to asking about:
the value, in U.S. dollars, on the last trading day of the year, of how much accumulation of capital market participants anticipate from equity ownership of five hundred large American corporations over a further time period, starting on the first trading day of next year and ending when they estimate said corporations will cease operations.
One last equivalence before the reader can restore breathing. Asking about the S&P 500 forecast this year means asking about:
the amount expressed in a non-everlasting fiat currency (i), whose collective acceptance depends on social affects, that represents stock market participants’ valuations, on the last trading day of the year, of all dividends (ii) to be captured from equity ownership of five hundred large American corporations over the period starting on the first trading day of next year and ending when they estimate said corporations will cease operations, adjusted by the opportunity cost (iii) of not dedicating the same economic resources to other investments with similar risk profiles.
One could go on and on and break down the problem into ever narrower assertions. One could hold forth about how intricate currency (i) is as a social institution and how fragile acceptance has always been, to the point where even Joseph Schumpeter admitted that he would always struggle to write about it. One could discourse on how dividends (ii) are closely tied to profits, themselves in turn defined by the difference between revenues and costs. The former is subject to the fickleness of consumers’ psychology and ever-evolving social needs and tastes, the latter to the fluctuating bargaining power of wage earners or, in other words, the instability in the balance of power between labor and capital. Not to mention how mutable an opportunity cost (iii) is. If one is to take seriously the neoclassical economics’ theory of objective value, and its most modern quantitative finance reinterpretations, then an opportunity cost is indistinguishable from the highly volatile required rate of return2. Said rate is driven by the economy’s interest rates, themselves determined by the elusive equilibrium between the economy’s variable level of savings and its no less variable level of capital investment needs.3
Do not focus on the seemingly technical language from the previous paragraph. Rather than do not focus on, I should say: do net get fooled by. In fact, the only key words in that paragraph were: fragile, fickle, ever-evolving, instability, mutable, volatile, and elusive. For economics is not a hard science. Its object, the economy, is contingent, mutable, and random since it depends on social interactions. It is not rules-based, stable, and predictable as objects of hard sciences who would follow mathematical laws, for example, much to the dismay of the mainstream financial press, almost every market commentator on TV, the most visible chief economists employed by investment banks, an overwhelming majority of investment managers, and most financial advisors, all of whom engage in the worst kind of esotericism, either deliberately or unconsciously, to manufacture a knowledge gap between their sphere and ordinary people, and do business. So Goldman’s chief U.S. equity strategist David Kostin showed up on CNBC in December 2021 and say, “our forecast for the S&P 500 in 2022 is 5,100” only for the index to drop to 4,100 six months later.4 Likewise, Jim Cramer tweeted “Netflix! Buy!” in January 2022, only for the stock to collapse and lose 70% of its value five months later. More critically, on September 4, 2008, Jean-Claude Trichet, then president of the European Central Bank, found himself explaining to the world that the economic slowdown from the first half of the year was a mere technical correction and that the economy would gradually recover from there. Lehman Brothers collapsed two weeks later and, to this day, the real level of economic activity in Greece is 30% lower than in 2008.
Finding the single right name for those finance professionals is one problem I have long struggled to solve. On the one hand, we face the vast majority who make blunt predictions about the markets in good faith, because they ignore the essence of economics. They are unconscious. That means dangerous. Frauds sounds fair as a name. On the other hand, we face the equally dangerous minority who is aware of the fallibility of its theories but who will nonetheless discourse in the lexicon of science, certainty, and predictability. This category is cynical and sly enough to make their claims quite unfalsifiable, so their careers on television and in corporations last longer. "Name a number, or name a date, but never name both," British PM Harold Wilson would say. The right name for those has to be obscurantists. To facilitate rant, I am tempted to take advantage of the all-encompassing name of charlatans. It does justice to both sociotypes.
Whether they are unconscious and inept or deliberate and cynical, our beloved charlatans have no excuse. They have long been warned that intrinsic theories of value — holding that the value of capital in particular can be estimated using objective measures and thus predicted in the future by extrapolating said measures into the future as well — are very weak tools. First by Newton who, when asked about the direction of the stock market at the dawn of capitalism three centuries ago, allegedly responded: “I can calculate the motion of heavenly bodies, but not the madness of people.” But the sharpest warning is to be found in the work of the great sociologist Émile Durkheim. In 1908, addressing an audience of economists at the French Society of Political Economy, he started by flattering his audience:
“At first sight, economics appears to deal with facts of a much different nature from the other social sciences. Morality and law, which form the subject matter of the other specified social sciences, are essentially matters of opinion. Wealth, which is the subject of economics, seems on the contrary to be essentially objective and independent from opinion.”9 (My translation)
And then he went hard on them:
“However economic facts can be approached from another standpoint; they are also a matter of opinion. For the value of things depends, not only on their objective properties but also on the opinions held about them. Doubtless, these opinions are partly determined by the objective properties; but they are also shaped by many other influences. If religious opinion should forbid a certain drink — wine, for example — or a certain meat — pork —, then wine or pork would lose some or all of their exchange value. Likewise, it is movements in opinion, in taste, which give their value to one fabric or precious stone rather than another…”10 (And one stock rather than another one would be tempted to say today.)
“It follows that the relations between economic science and the other social sciences appear in a different light. They all deal with phenomena which, considered at least from certain angles, are homogeneous, because they are all, in certain respects, matters of opinion… Economics thus loses the predominance it has invested itself with, to become a social science alongside the others, in a close relation of solidarity with them, with no valid claim to rule over them.”11
As you might have expected, his diatribe was met with scandalized rejection by the economists at the conference.
Protect yourself from the noise
Lifeworks is different from charlatans who make market calls doomed to be proven wrong with a 50% probability and right with a 50% probability, owing to the undeniable fact covered above: goods and services’ prices and asset values are not predictable because they are mostly set by random social interactions. Predictions are noise, not information. The Krugman v. Summers dispute on inflation that took place in the first quarter of 2021 is a case in point. Paul Krugman is a professor at Princeton, a columnist at the New York Times, a recipient of the Nobel Prize, he studied at Yale and the MIT, and has published countless essays and papers. Larry Summers is a professor and president of Harvard University, a former U.S. Treasury Secretary, and former Chief Economist at the World Bank. The two economists are equally “qualified” (quotation marks warranted) on paper, can boast equally prestigious “knowledge” (idem) certificates, and wear the same suits. Still, on February 4, 2021, a column by Larry Summers in the Washington Post warned about the inflation risks from the Biden stimulus and sparked vehement debates… While Paul Krugman was taking the opposite stance. Summers had a 50% chance of being mostly right, and he ended up being mostly right, in part owing to persistent Covid variants in Asia and the war in Ukraine, both being unexpectable when he made his call in early 2021. Krugman had a 50% chance of being mostly wrong, and he turned out to be plainly wrong. In many other instances over the past thirty years, Summers got his calls wrong, and Krugman his right. In other words, they produce noise. Like suits, like backgrounds, different year: Ray Dialo, a successful asset manager, is now making the prediction that inflation will remain around 7% by the end of 2022 and David Rosenberg, a well-spoken economist, was forecasting three months ago that inflation would soon go back down under 2%. No one can know which will turn out to be right out of chance, and which wrong out of misfortune, but like Summers and Krugman, both are still speaking in the lexicon of science, certainty, and predictability.
It is our duty to disillusion our clients who, like millions of other Americans, risk being deceived by the business models of charlatans whose sole competency consists in hiding the randomness of the world, with undeniable talent, behind phony arguments and well-worded glosses, with the purpose of selling their views and outlooks, and justifying their values and fees.
Financial news and “information” (quotation marks warranted) are not only generally useless, but they are also toxic. Minimal exposure to mainstream business and financial media should be an iron rule for someone responsible for making decisions under uncertainty (namely CNBC, the WSJ, the Financial Times, the Economist, and most of Bloomberg’s contributions.) Spending hours studying the news does not have a positive impact on your knowledge of the world and makes no (or a negative) difference to your understanding of social processes and your predictive abilities.
I will go one step further and throw even the most specialized “experts” into the same bucket. Equity research analysts, whether they are employed by investment banks or by independent research shops, usually follow only a dozen stocks within the same industry, ten hours a day, and for as long as their careers last. They dedicate decades to the narrowest area of economic knowledge possible. Their work consists in forecasting the ex-ante (unknown) 12-month stock price of a company. Yet, multiple studies will help you conclude that, in aggregate and over time, they fare worse than a fictional ordinary joggers-wearing high school student who would simply use as his 12-month price forecast today’s price increased by 8%, the average market rate of return over the past 40 years.
The right benchmark
At Lifeworks, we do not make market outlooks front and center of our decision-making processes, and we do not make beating the market an objective of our investment system.
First, market outlooks by money managers are meaningless and value-destroying most of the time.
I say meaningless because, whether deliberately or unconsciously again, they do not provide a comprehensive and falsifiable description of a future state of the world. Consider this example. Mr. Client, in light of the current supply and demand imbalances triggered by the recent lockdowns in China, considering the relatively slow pace of quantitative tightening by the Fed, let alone by the ECB and BOJ, and taking labor market tightness and wage-price spirals into account, my outlook is that global inflation is entrenched and will work as a tailwind for financial asset prices. I hope you liked my outlook Mr. Client, because it reads relatively well and you will never be able to prove me wrong. What inflation? CPI? PPI? PCE? Entrenched? Until when? At what exact level? Huh, tailwind you said? What do you mean? Is the tailwind priced in already? Huh, not priced in? What assets? Exxon Mobil’s stock? Or Chinese government bonds? So, according to you, the market is wrong? What insider information do you have that the market doesn't? You’re talking to Putin’s advisors? He will withdraw his army from Ukraine and energy pressures will ease? When? Before or after the next Fed meeting? And so forth. I say value-destroying because it is not possible to take decisive action based on them. They give a false impression that a course of social events is deterministic when history and our present and humble summary have proven that it is not. And these outlooks always cost something, be it time or money — sometimes it is both. So they actually destroy value on average.
Second, beating the market is a matter of chance, not skills. And we do not want to get paid to be lucky. Let’s try a quick thought experiment. Construct a population of 100 fictional investment managers. Assume they each have a 50% probability of beating the market at the end of the year, and a 50% probability of losing to the market. Assume that a bad year is redhibitory in the sense that a losing manager is thrown out of the sample. At the end of the first year, 50 managers are expected to remain. Now we run the experiment a second time. 25 managers will be winners two years in a row. Another year, 13, a fourth one, 6, a fifth 3. Out of thin air — or rather, pure luck — we have given birth to 3 managers who will now show off on CNBC or Bloomberg, like Cathie Wood in December 2020. But, unlike skills, luck doesn’t bear fruit every spring, and Cathie Wood’s ARK ETF has been down 70% since her media parade. I love Bill Gross’ honesty for that reason. Bill Gross is a world-acclaimed fixed income investor whose strategies earned him the nickname of “Bond King”. In an introspective piece written in 2013, he repudiated his title:
“Time and longevity must be a critical consideration in any objective confirmation of ‘greatness’ in this business. 10 years, 20 years, 30 years? How many coins do you have to flip before a string of heads begins to suggest that it must be a two-headed coin, loaded with some philosophical/commonsensical bias that places the long-term odds clearly in a firm’s or an individual’s favor? I must tell you, after 40 rather successful years, I still don’t know if I or PIMCO qualifies. I don’t know if anyone, including investing’s most esteemed ‘oracle’ Warren Buffett, does… Let me admit something. There is not a Bond King or a Stock King or an Investor Sovereign alive that can claim title to a throne. All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience. Since the early 1970s when the dollar was released from gold and credit began its incredible, liquefying, total return journey to the present day, an investor that took marginal risk, levered it wisely and was conveniently sheltered from periodic bouts of deleveraging or asset withdrawals could, and in some cases, was rewarded with the crown of ‘greatness.’ Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.”
At a given time in the market, the most famous investors are likely to be those that are fit to the latest regime. If they are lucky, no regime change occurs until they retire. But the attributes of modern neoliberal capitalism may not be everlasting — a floating and hegemonic U.S. dollar, central banks following mostly price stability and growth objectives independently from any day-to-day control by the people, deregulated international capital markets, low trade barriers — and should a regime switch occur, randomness would change in shape, and a few market kings would be blown away. When that would happen exactly, what shape would new randomness take, who would get sunk, and who would get buoyed, is impossible to say today.
For these reasons, Lifeworks is not trying to beat the market. Neither are we trying to position portfolios towards equities when we think equities will boom and towards bonds when we think they will. We are no more manufacturing market outlooks. It does not imply that we are nihilists who reject all financial tools or spectators who support a wait-and-see policy.
We employ tools differently. First, we do not shy away from unveiling the lazy and thus lucrative business model of charlatans in our industry. By doing so, we avoid making the same mistakes as them. Second, we strive to humbly build the most resilient portfolios possible that will hold value across different market regimes. Third, we define the right benchmark for your investment portfolio as your financial plan—not some arbitrary index that may go up or down by 30% or more at any point in time.
Swedberg, Richard. “Schumpeter: A Biography.” Princeton University Press, 1991.
Sharpe, William F. “Capital Asset Prices – A Theory of Market Equilibrium Under Conditions of Risk”. Journal of Finance, 1964.
Keynes, John M. “The General Theory of Employment, Interest and Money.” Palgrave Macmillan, 1936.
Introductory statement to ECB’s press conference on September 4th, 2008. https://www.ecb.europa.eu/press/pressconf/2008/html/is080904.en.html.
As quoted by Lawrence H. Summers. The source is unclear and this quote may be apocryphal.
Carswell, John P. “The South Sea Bubble.” 1960. The source is disputed and this quote may be apocryphal.
Durkheim, Émile. “Débat sur l’économie politique et les sciences sociales.” Conference at the French Society of Political Economy, 1908.
Summers, Lawrence H. “The Biden stimulus is admirably ambitious. But it brings some big risks, too.” Washington Post, 2021. https://www.washingtonpost.com/opinions/2021/02/04/larry-summers-biden-covid-stimulus/.
See for example Bonini, Stefano and Zanetti, Laura and Bianchini, Roberto and Salvi, Antonio. “Target Price Accuracy in Equity Research.” Journal of Business, Finance and Accounting, Forthcoming, 2010.
Gross, William H. “A man in the mirror.” Pimco Insights, 2013. https://www.pimco.com/en-us/insights/economic-and-market-commentary/investment-outlook/a-man-in-the-mirror/