Leithner Letter No. 32
26 August 2002

We are not in the midst of a financial panic, and recovery isn’t simply a matter of restoring confidence. Indeed, excessive confidence may be part of the problem. Instead of being victims of self-fulfilling pessimism, we may be suffering from self-defeating optimism.

The New York Times (14 August 2001)

What’s happening, against a case of strenuous denial, is that we are seeing the slow death of a delusion – a delusion that the U.S. economy was in a new era capable of producing endless growth without interruption forever. The message is not that earnings will go down, but that the market doesn’t know any more what price to pay for those earnings.

The Australian Financial Review (22 July 2002)

America Inc. Revises Its Accounts

Australia’s most prominent corporate laundry is presently being wrung, semi-publicly, at the One.Tel liquidator’s inquiry and The HIH Royal Commission. America’s hamper, fuller and rather dustier, contains (among others) Bristol Myers-Squibb, Enron, Global Crossing, K-Mart, Rite Aid, WorldCom and Xerox. But individual private businesses and public companies are not the only entities whose accounts have recently been amended and subjected to scrutiny. On 31 July the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce, which collects and collates a range of economic data, released figures that revise – in some instances substantially – that country’s recent commercial history.

Revisions of aggregate economic data are common because government statisticians must necessarily rely upon the limited amounts of information that are relatively quickly available (plus educated guesses regarding what is not yet available or will never become available) to produce initial estimates; then, as information from less-frequent but more comprehensive surveys (together with tax, unemployment and other records) come to hand, these initial estimates are revised. Aggregate economic data, it is therefore important to remember, are approximations. As such, and despite the diligence and intelligence of the people who compile them, they inevitably contain errors and are subject to revision; moreover, at all times their veracity depends ultimately upon the assumptions used to compile them.

Hence a critically important caution: as Oskar Morganstern (On the Accuracy of Economic Observations, Princeton University Press, 1963, ASIN: 0691003513) wrote a generation ago, “textbooks on national income and macro-economics show little if any evidence of the awareness of their data’s difficulties and limitations. In Great Britain, as in the U.S. and elsewhere, national income statistics are still being interpreted as if their accuracy compared favourably with the measurement of the speed of light.”

The amended figures released on 31 July indicate not only that the pace of economic activity during the first half of 2002 was slower than previously thought; the data also seem to show that activity is decelerating from these lower levels. Annualised growth of Gross Domestic Product, a misleading statistic upon which many market participants obsess, once thought to be a blistering 6.1 per cent in the first quarter, has been revised to a merely hot 5 per cent; and its counterpart for the second quarter, previously expected to be a warm 2.5 per cent, is now reckoned to be a downright tepid 1.1 per cent.

A range of other figures for 1999, 2000 and 2001 has also been revised. GDP shrank in three (and not just one as previously thought) of the four quarters of 2001, and estimates of corporate profits during these three years have been lowered by 6 per cent or $US143 billion. Indeed, rather than peaking in 2000 it now seems that profits actually crested during the third quarter of 1997 and have been falling almost continuously thereafter. This alteration is particularly startling. Given the figures available at the time, during the height of the mania in early 2000 it occurred to no one that corporate America was actually mired in a nasty profits slump. On a pro forma basis, companies were reporting respectable increases in earnings per share and were meeting or exceeding the all-important “expectations” of analysts. Further, Dr Greenspan lauded their profitability and the Department of Commerce’s initial estimate of profits in the second quarter of 2000 indicated that they were 15 per cent greater than during the corresponding period in 1999.

Since then, these estimates of corporate profitability have been repeatedly amended. And at each successive revision these estimates have fallen. It now appears that profits during 2000 dropped 11 per cent below the (also revised) 1999 total of $US518 billion, and fell no less than 17 per cent below the overall 1997 figure of $US556 billion. Alas, it is quite possible that the bad news for 2000 and 2001 has not percolated fully to the surface. As firms such as WorldCom restate their profits they will refile their tax returns; and as individual companies submit amended tax returns and additional and more complete information is generated, aggregate figures will change. Hence the BEA’s estimates of profit and other economic activity for 2001 and 2002 remain subject to further revision, and perhaps to downward adjustment.

A Profit Crunch To Remember

Members of the Baby Boom generation were reared by parents who were, to a greater or lesser extent and in one way or another, moulded by the Great Depression. In contrast, Boomers reached adulthood in an age during which the economic sun generally shone brightly and experts agreed virtually unanimously that a depression could not return. Activist monetary policy, automatic fiscal stabilisers and (in the U.S.) bank deposit insurance would make such a calamity impossible. And despite mild recessions in the 1950s and 1960s and more severe ones during the 1970s and 1980s, since the early 1940s the residents of no Anglo-American country (New Zealand is a possible exception) have experienced a depression: indeed, the very word has been banished from the polite lexicon.

As a result, Boomers’ children, the Generation X’ers, have no direct experience, little or no inherited knowledge and thus no predisposition to recognise signs of economic depression. This is significant because the ranks of funds managers, analysts, brokers and financial planners, bankers and business people more generally, are consisting more and more of X’ers and less and less of those whose characters and life experiences were forged by the adversity of the 1930s.

It is both timely and salutary, then, that Barron’s (15 July) observed that “what we are witnessing in earnings in recent quarters is a Great Depression in profits, a collapse in earnings as deep and as frightening as anything we have seen since our [forebears] were scarred for life. Since peaking in the third quarter of 2000 [sic], S&P 500 earnings have fallen more than 50%. This is the greatest percentage drop since the early 1930s. S&P profits have fallen to roughly the same level they were in 1993 – the longest period of no growth since the decade of the 1930s. Profits of the Dow 30 have fallen by close to 40% since their peak in the fall of 2000. Again, this is the worst dive in the Dow’s earnings since the early 1930s.”

Barron’s also emphasised that in certain sectors the story is even worse. It is well known that the American telecommunications and information technology sector can barely swing its legs out of bed in the morning. The earnings of companies in this sector have collapsed from an annualised rate of $US23 billion in the (northern) autumn of 1997 to a current annualised loss of $US9 billion. Similarly, in 2001 the primary metals sector incurred hefty losses for the first time since 1992. In contrast, very few recognise that America’s motor vehicle industry, whose sales and capital base are far greater today than 40 years ago, is presently generating profits of almost exactly the same absolute magnitude as those earned during the late 1950s and early 1960s. Adjusted for the debasement of the $US, and despite the scores of billions of capital ploughed into the industry over these years, Detroit’s profits today are a meagre one-fourth of what they were during the Eisenhower and Kennedy administrations.

More generally and much more disturbingly, the profits of America’s manufacturing industries are, considered as a group, roughly half of what they were in mid-1997. Barron’s concludes: “this is a stunning, uniquely large drop. For all of the economy, including non-publicly traded companies, corporate profits are off roughly one-fourth from what they were at their peak in late 2000. Again, this is a unique fall in the post-war era.”

Considered as a whole, then, and despite the weaknesses that inhere in aggregate-level data, the figures released by the BEA on 31 July indicate that American economic conditions in 2001 were feebler than was previously thought; that current conditions are less robust than previously reckoned; and that conditions during the remainder of 2002 are likely to be more anaemic than expected hitherto. It also transpires that labour income in 2001 had been overstated by $US148 billion. By comparison, WorldCom’s revisions were insignificant; and by implication, heaven help taxpayers if Uncle Sam should ever place his ramshackle accounts on a sound footing.

The Future’s Not What It Used To Be

In the words of the American sportsman Laurence (“Yogi”) Berra, “it’s tough to make predictions, especially about the future.” Yet bold as brass and without a hint of embarrassment, many market participants (particularly “analysts” and “strategists”) continue – even after the various débâcles of the past few years and the turbulence of the past few months – to make predictions and to pretend that their prognostications will correspond to reality.

They almost invariably forecast whilst wearing rose-tinted spectacles. According to The Wall Street Journal (1 August), for example, “many experts still say a so-called double-dip recession is only a remote possibility, but concerns about a near-term slowdown are likely to shadow the nation’s markets and businesses.” On the basis of the recent form of these “experts” the opposite conclusion, i.e., the occurrence of a “double-dip,” is a reasonable proposition. The Weekend Australian Financial Review (27-28 July) noted that “over the past three years market forecasters have rarely had enough time to wipe the egg off their faces before the next batch of free-range barnyard best have landed on target.”

The table below, which summarises the “market predictions” of a range of major investment institutions, provides a typical example. On 15 July The AFR published with respect to a variety of economic phenomena in Australia – including the level of the All Ordinaries index – on 31 December 2002. Eight of these institutions’ predictions appear in the table. It shows that heavyweight market participants are unanimously optimistic about the general price level of Australian equities; none, in other words, is expecting that it will fall. Their average prediction (3,436) implies that by the end of 2002 the All Ords will rise 9% above its close on 30 June and 11% above its close on 9 August.

Similarly, The Financial Times Weekend Edition (15-16 December 2001) published British institutions’ predictions about the level of the FTSE 100 index on 31 December 2002. Each of these forecasts is set out in the table. Again, Pollyanna rules: without exception, prices are forecast to rise. Indeed, the average prediction (5,838) is dramatically higher than the closing level of the FTSE on 30 June (4,686). If these forecasts are to correspond to reality (many were revised downwards during the first half of 2002) then during the second half of 2002 the FTSE must rise by 25% from its close on 30 June.

Market Predictions and Market Reality in Three Countries

Australian Institution Target Level for
All Ordinaries Index
(31 December 2002)
ABN Amro 3,500
AMP Henderson 3,450
Deutsche Asset Mgmt 3,335
HSBC 3,450
JP Morgan 3,450
Macquarie Bank 3,400
National Australia Bank 3,400
UBS Warburg 3,500
(Mean Prediction) 3,436
British Institution Target Level for FTSE 100 (31 December 2002)
ABN Amro 5,800
Deutsche Bank 6,200
CS First Boston 5,900
HSBC 5,700
Lehman Brothers 6,000
Merrill Lynch 5,350
Morgan Stanley 6,000
UBS Warburg 5,750
(Mean Prediction) 5,838
U.S. Institution Target Level for S&P 500(31 December 2002)
Bank of America 1,200
CS First Boston 1,375
Edward Jones 1,240
JP Morgan 950
Lehman Brothers 1,350
Merrill Lynch 1,200
Salomon Smith Barney 1,300
UBS Warburg 1,570
(Mean Prediction) 1,273

Befitting an optimistic land and people, in mid-2002 the prognostications of major American investment institutions were the most erroneously optimistic. USA Today (2 January 2002) published their predictions about the level of the S&P 500 index on 31 December 2002. Each of these forecasts is listed in the table. Only one of the eight envisages a fall in the level of equity prices during 2002. Alas, the average of 1,273 is dramatically higher than the S&P’s closing level on 30 June (972). If these prophesies are to correspond to reality (they too have subsequently been revised downwards) then during the second half of 2002 the S&P 500 must rise from its close on 30 June by no less than 31%.

Don’t They Ever Learn?

Some important generalisations and lessons for investors emerge from this table. First, what Mr Buffett has called the institutional imperative continues to thrive inside major investment institutions. In the words of The FT (31 December 2001), “forecasters tend to move in a pack. Few enjoy life far from the consensus. Your job is safe if you are wrong alongside others. Following your convictions puts your job at risk.” Similarly, economist Gary Shilling reckons that “a lot of economists never forecast recession because it can be very detrimental to your job security” (see also Irving Janis, Groupthink: Psychological Studies of Policy Decisions and Fiascoes, Houghton Mifflin College, 1982, ISBN: 0395317045).

Second, as Alan Kohler has argued (The AFR 19 June 2001) many “professionals are obviously no wiser to what’s going on than [small investors] are.” Clearly, everyone has a right to be wrong; equally plainly, some are stretching that privilege. Accordingly, ”investors may be examining the latest batch [of strategists’ forecasts] with a sharper eye than usual: the strategists’ track record over the past two years has been less than sterling. ... This past year, for the second year running, almost every strategist on Wall Street got it wrong. Even the most bearish of them overestimated stock strength in what is shaping up as the market’s second down-year in a row” (The WSJ 10 December 2001).

Similarly, The FT (15-16 December 2001) observed “it has to be said that strategists did not exactly cover themselves with glory this time last year. The lowest forecast (from Merrill Lynch) for the FTSE 100 index was 6,600, more than 1,000 points above the likely outcome; not one strategist correctly predicted the direction of the market, let alone the scale of the fall. And 2001’s failure was not a one-off; the strategists were also completely wrong as a group about the prospects for markets in 2000.”

This point, alas, generalises far and wide. In 1999 Prof Ron Bird, together with John McKinnon and Brett McElwee of Grantham Mayo Van Otterloo, completed a study of analysts in 21 countries. Their conclusion, in the words of Barrie Dunstan (The AFR 27 April 1999) “doesn’t flatter investment analysts or produce a lot of confidence in the conventional investment process.” In most countries, analysts’ forecasts were overly optimistic, and those employed by stockbrokers evinced the greatest over-optimism. Australia was one of the countries where the consensus estimates were most inflated. Here, the average forecast was about 30 per cent above the actual for two-year forecasts and about 15 per cent too high for one year forecasts.”

Dunstan continues: “what was even more worrying is that the consensus forecasts by highly-paid analysts are not as good as the results from the simplest forecasting techniques. How simple? Well, try a forecast that next year will be the same as this year. This so-called naïve approach beat the analysts’ consensus forecasts by a ratio of seven-to-one in one-year numbers and by 10-to-one for two-year forecasts. In fact, says the [GMO analysis], ‘it would appear that the over-optimism of the analysts outweighs any identified advantages that the analysts have over other forecasting methods.’”

According to The WSJ (10 December 2001), “the real problem, many strategists agree, is that [in 2001 they] simply didn’t appreciate how much the stock market had been overpriced during the bubble of the late 1990s and failed to anticipate the inability of these overvalued companies to continue generating eye-popping profits.”This claim raises the obvious question: if “strategists” neither properly appreciate nor accurately anticipate, then what on earth are they paid so lavishly to do? Glen Stevens, Assistant Governor of the Reserve Bank of Australia (quoted in September 1999 by then-AFR correspondent Stephen Koukoulas), believes that many people prophesy “with a view to selling a product, or a piece of advice. ... many forecasts made in the private sector are essentially of this variety. The forecaster has a story to tell in order to provide credibility to their employer’s efforts to win business.”

Go Flip a Coin

How accurate are forecasters’ predictions? Despite his insatiable appetite to divine and his incessant desire to convince his fellows of his prescience, homo sapiens has no valid and reliable means to peer into the future. Economist Gary Shilling asks rhetorically: “if any of us really knew what lay ahead, why would we be sharing that priceless information with anyone else? We’d be making so much money, we wouldn’t know what to do with it.” Yet economists do not figure prominently – indeed, at all – on the BRW Rich List.

William Sherden (The Fortune Sellers: The Big Business of Buying and Selling Predictions, John Wiley & Sons, 1999, ISBN: 0471358444), a management consultant and poacher turned gamekeeper, has examined the multi-billion dollar business of buying and selling predictions in fields ranging from finance and economics to management, weather and demography. Sherden shows that forecasting is typically based on conjecture and often on the mere extrapolation of past trends, i.e., something that is no more sophisticated than what a child can do with a pencil and ruler. Aside from one-day weather forecasts and the ageing of the population, few forecasts are more reliable than flipping a coin. Indeed, many forecasters are no better than astrologers and fortune-tellers: the major difference is that they charge vastly more for their time and services.

Forecasters’ advanced university degrees, impenetrable jargon, multi-equation mathematical models and high-powered computers are thus a smokescreen. Accordingly, Padraic McGuinness reckons “the only honest position with regard to economic forecasting at present is agnosticism” (The Sydney Morning Herald 28 November 1999). This, in essence, is why Leithner & Co. ignores “the market” and “market gurus,” and why it does not try to predict “the market.”

More generally, it is also why value investors discount expert predictions. Alas, “it’s just as bad when you’re crystal-balling the Big Picture – macro-economics, the fate of nations, the strategic future. Tim Van Gelder of Austhink has been looking at how some of the world’s greatest thinkers have gone, helping us negotiate uncertain times by signposting our futures. The answer, perhaps unsurprisingly, is not so well. He cites, for instance, Philip Tetlock of the University of California, who has for 15 years been asking experts in academe, intelligence organisations, investment banks, groups like the International Monetary Fund, their best estimates of five-year futures. Tetlock concludes: ‘almost as many experts as not thought that the Soviet Communist Party would firmly remain in the saddle of power in 1993, that Canada was doomed by 1997, that neo-fascism would prevail in Pretoria by 1994, that the European Monetary Union would collapse by 1996, that Bush senior would be re-elected in 1992 and that the Persian Gulf crisis would be resolved peacefully’” (The Weekend AFR 27-28 July 2002).

Who’s Laughing At Whom?

The crux of Sherden’s excellent book is that confidence in forecasters and “experts,” and belief of their predictions, is the modern counterpart of ancient superstition. It is also the grown-up version of the Tooth Fairy and Easter Bunny. But it is hardly harmless: individuals and businesses pay billions of dollars to acquire information that is mostly useless. Even worse, uncritically to believe the experts and blindly to act upon their forecasts is (given their dismal track records) to base actions upon faulty premises and false reasoning. To act in this manner, in turn, is to place people, businesses and governments at financial risk.

If today’s forecasts have no more rational basis than the superstitions of a thousand years ago, then why do people continue to heed forecasters? The answer, according to one psychologist who studies human beliefs, is that humans are innately gullible. The research of Daniel Gilbert of the University of Texas indicates that people tend to believe what they see and hear. Only secondly (if at all) do they doubt and ask questions. Humans are also very poor judges of probabilities; drastically under-rate the role of pure chance and thus have strong tendency to infer patterns where none exist; are prone to base decisions upon irrelevant information; and are heavily influenced by authority figures. In short, people are innately and psychologically prone to allow “expert” predictions, regardless of experts’ poor track records, to bamboozle them (see also Massimo Piattelli-Palmarini, Inevitable Illusions: How Mistakes of Reason Rule Our Minds, John Wiley & Sons, reissue edition 1996, ISBN: 047115962X; and Thomas Gilovich, How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life, The Free Press, 1993, ISBN: 0029117062).

Our Whiggish hubris blinds us to the fact that these foibles are as prevalent today as they were in ancient times. In the Roman Republic, a college of seers examined the organs of sacrificed animals and, inferring from these entrails, uttered prophesies about all manner of things. It is said that Cato the Elder once wondered how one soothsayer could look another in the face without laughing. Sherden’s message is that we must ridicule our contemporary gizzard-squeezers: otherwise they will continue to laugh all the way to the bank with our money. Similarly, The FT (31 December 2001) concluded “if the value of most economic forecasts is far below their price or the attention given to them, a large part of the blame must lie with the users. Those who listen credulously to economic soothsayers have little right to feel aggrieved.”

How, Then, to Proceed?

First, recognise that to disclaim any ability to foresee the future is not to ignore the future. Quite the contrary: Leithner & Co. plans for the future by considering scenarios – and particularly dour scenarios – of what might happen (as opposed to predictions of what will happen), and then allocating capital accordingly. In this context it is highly significant that, according to Prof. Terrance Odean of the University of California-Davis (quoted in The WSJ 22 September 1998), “psychologists have found that people who are mildly depressed tend to have the most realistic outlook.”

Second, the focus should be neither the macro-economy nor financial markets as a whole; rather, it is upon individual companies. Third, the obsession with prediction blinds us to the existence of relatively simple, valid and reliable rules of thumb, grounded in axioms of human action, that provide a rational basis for capital allocation.

Finally, and perhaps most importantly, keep worthy role models uppermost in mind. Since the 1930s, and through thick and thin, value investors such as Benjamin Graham, Walter Schloss and Warren Buffett have invested successfully and created significant wealth for their co-venturers by basing their investment decisions upon a thorough and cautious analysis of companies’ financial statements and by keeping their own counsel.

According to Mr Graham, “you are neither right nor wrong because the crowd disagrees with you.” Rather, “you are right because your data and reasoning are right.” At the same time, however, and as he also emphasised, “the right kind of investor [takes] added satisfaction from the thought that his operations are exactly opposite to those of the crowd.” Leithner & Co. is therefore reassured by the fact that Graham’s principle of buy-and-hold is presently misunderstood and disparaged by prominent columnists in well-known publications. After all, if the “experts” are against us then common sense may well be with us.

Chris Leithner


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