In financial markets there are plenty of talking heads on CNBC and Bloomberg TV making predictions, estimates and at times guess-timates. There are good ones and bad ones. Good ones does not necessarily mean the correct ones in the end. Good ones are those that have been well argued, brave and honest. Stock Research - good or bad?
Good predictions are an essential trait for strong independent and respected research. Let’s start with stock analysts. A stock research report has many limitations. It can only look at the over-riding factors and variables affecting the business specific. Sometimes it becomes unfair to attribute non-performance to poor research, when there could be bigger macro or external factors at work – e.g. earthquake, big credit default by a government, sudden devaluation in a currency, political upheavals, etc.
Good predictions ought to include a history of previous recommendations, timely upgrades or downgrades. Is it necessary to have a target price? Strictly speaking, a stock research report makes a judgment on the prospects of the business and strategy. If an analyst thinks its good, how good is it? Hence a target price commits an analyst to affix a fair value or indicate how high it should go to. By that token, a sell report should also indicate a price where the stock could collapse to.
The other camp would argue that target price is too exacting. A buy (+10%) or strong buy (+20%) would be more realistic as prices tend to overshoot. It also leaves room for the investor to bail out if there are over-riding macro concerns or significant shifts in sentiment. The same investor could let a performing stock to run some more if the sentiment and trend are showing positive signs.
The blind spots
If you ask ten experts to predict where the KLCI will be at the end of the year, and to have them write a 1,000 word essay justifying their viewpoint, you will probably get a nice distribution of predictions.
Say, you get a range from 1,000 to 1,500 with most of them congregating around 1,300. What would most interest me is the views on the two extremes, not the middle of the pack. The middle perspective would probably contain views that most people know or which are already widely elaborated in the financial media.
But they chaps who made the call at 1,000 and 1,500 are likely to have some strong views on certain issues. They may be wrong or they may not be, but they are always likely to have something interesting to say.
I have learnt, after many years of reading the financial markets, that following the crowd will more often than not, lead you to destruction. On the other hand, the “extreme views” carry more weight because great losses and gains come about through “blind spots” which are not in the general public’s `field of vision’. This does not mean they will be right. You still need to put on your thinking cap to assess the validity of their arguments.
Two-handed predictions
What I most detest are predictions that are so well hedged that they become vague. For example: “I think the KLCI will break 1550 this year. However, on the other hand, higher oil prices and inflation may not allow that to happen.”
That may seem like fair comment but the pundit is hedging his bet. In the event the KLCI breaks 1550 or even if it does not, the pundit’s prediction would not have been wrong. We need more “one-armed” economists. By this, I mean those who do not say “on the other hand”. Hedged views only means the pundit is unsure. But gee - aren’t these people paid a whole load of money to provide a certain view?
I prefer analysts who stick their necks out with brave and honest views... those who promulgate a view and are passionate about them. If one sticks his or her neck out and gets six or seven out of 10 right, they’re on their way to a bright career.
Hedged views could sometimes indicate sloppy and sluggish research views. Have you heard this joke? “An economist is someone who tells you why their previous prediction went awry.”
Airy-Fairy projections
The worst kind are airy-fairy ones. For example: “The KLCI will reach 2000 over the next few years.”
What good are such statements!? What does “few years” in this context mean? Three? Maybe 5 years? Could it even mean 7 years? These are the predictions one ought to be wary of, as the pundit is trying very hard to avoid making the wrong call whilst seemingly issuing a strong call/statement.
Talking about big calls, here’s one - Goldman Sachs’ recent prediction that oil prices will reach US$200 within the next 12-18 months.
On the other hand (deliberate use of that phrase here), making a forecast that the market will hit 2000 is a very weak call. One might as well not make one. I’ll tell you why. Let’s start with the 1300 point level. Based on a 10% annual compounded gain, we could see the CI in 2008 at 1430 points; 2009 at 1573; 2010 at 1730; 2011 at 1903; 2012 at 2093.
See what I mean? It’s not a major call at all, and definitely not when used alongside an ambiguous time horizon of a “few years” or even worse still “in future”.
Predictions are meant to be useful to guide investors to make investment decisions. Vague calls that are essentially hedged bets serve no such purpose.
There seems to be just too many well-hedged views by analysts, fund managers, economists as well as CEOs. The media fraternity should probe more when faced with such vague calls.
The Variables
Predictions on stocks or the markets involve taking into account a multitude of variables. A computer model may be better as it can assign values to all of these variables. If a stock has 20 variables, a computer model can compute a final figure with different weighting given to each variable (based on historical data).
An expert decision is more valued if he/she is able to point out the few critical factors or catalysts representing their predictions.
Trouble is many experts, when faced with these variables, do not have a clue on which are more important. Even when he/she is able to point out the critical factors, he/she may fail to see that those factors may already be in the price.
Based on the critical factors, one must be able to make solid estimates of the trend and consequences. Using the chess analogy, an expert player can probably see 4-5 moves ahead while a grandmaster can see the probable outcome of the next 9-10 moves.
Anchor & Adjust
The majority of investors will base their investing decisions on this technique - anchor & adjust. A&A is highly useful and relevant for daily decision making or snap decisions.
For example: You are at the mamak stall with your friends. The conversation turns to rising inflation.
Someone asks what the CPI (consumer price inflation) will be for the rest of the year. You remember that the most recent figure was 3.3%, so you anchor that. Then you try to factor in the huge spike in fuel prices recently, and you adjust it to say 4.5%. You really have no solid basis but its a good guess-timate.
But when we employ A&A for investing decisions, we usually end up with a one dimensional view. If we were asked now where the index will be by October, the anchor would be 1,190 (or thereabouts). If we are bearish, we will say 1100 or if we think oil prices may correct, we could say 1,300. Get it?
Still, we will fail to see the forces that could whack the A&A out of the water. The assumption is that the current level is the center of the earth and any adjustments would vary alongside and be based on that center. Remember - the center is a moving target. Just a few months ago, when the CI was at 1500, if you asked people the same question, they are likely to pick 1,300 as a bearish view and 1,600 as a bullish view.
If you made investing decisions based on that A&A, you would have been very wrong, especially if you were bullish. Even if you were bearish, you would have bought at 1,300. The A&A approach fails to identify how certain events can enlarge and exacerbate the status quo.
Which is why extreme corrections and bull runs always get the A&A investors caught out. You ought to constantly review and monitor the situation as opposed to holding on to a view that was made a couple of months ago. The situation is fluid. Investing is fluid.
p/s photos: Reon Kadena
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