“There is a science to investing.”

Given the market volatility and the steep declines of the last year or so, which quote would you agree with?

My answer is that I agree with both statements.  Here’s why.

Absolutely no one can successfully predict the short term direction of the stock market, the value of the dollar or gold, the movement in interest rates, etc., etc. When it comes to investing, there is no magic formula. There are no gurus who can foretell the future and help you “beat the market.”

On the other hand, there are approaches that work very well in the long term. For example, there is a fundamental relationship between risk and (expected) return. Ignore it at your own peril.

And you can learn from the past; you can devise a sensible strategy. Most of all, by following a long term buy-and-hold approach with a diversified portfolio that is matched to your risk tolerance, you can avoid the big mistakes of being too optimistic or too pessimistic.

For a thorough presentation on the intellectual underpinnings of a buy-and-hold approach and what investors should consider as they move forward, I highly recommend the video, What Should Investors Do Now? by Weston J. Wellington of Dimensional Fund Advisors.

This multi-part presentation includes “an examination of capital markets, the effects of recession and government policy on stock prices, how the current market stacks up to previous downturns, and the reasons why our core beliefs have not changed in light of these events.”

If you hold an MBA in Finance, you’ll find this video to be a valuable review of capital markets and portfolio management. If, like most people, you’re merely an ordinary investor, one just trying to figure things out, this will be an extremely useful introduction to the evidence that supports a sensible  long- term approach to investing.

So, grab a cup of coffee or tea, then sit back and enjoy the show. It is over an hour long, but you can view it in segments.

Watch it here.

Is it possible to be as proud of a friend’s child as you would be of one of your own?

Adam Baff, whom I have known for 30 years, is the son of close friends. Adam has many talents, and recently he wrote the music and lyrics for the Dow Jones Music Video.

I think it is very well done and effectively uses humor, irony, and great visuals to express the many moods we’ve all experienced. No doubt, for many of us, the last few months have been “trying” (to say the least), but Adam’s tongue-in-cheek view of life in these United States gives us something to smile about. Adam’s band Downsize performed the music, and the video features Nicole O’Connell an aspiring model/actress.

The link to the YouTube video is here.

The song is available for purchase at Amazon.com and also through iTunes.

So, I ask again, is it possible to be as proud of a friend’s child as you would be of one of your own? Absolutely! Way to go, Adam.

Last month, in an article titled Why the Experts Missed the Crash, Money Magazine published an interview with UC Berkeley Haas Business School professor Philip Tetlock. The professor has spent his career evaluating experts and authorities in a variety of fields, and he is not at all surprised that the vast majority of financial “gurus” failed to predict the recent steep market decline.

Here is a summary of the article:

Despite everything, we can’t shake the belief that elite forecasters know better than the rest of us what the future holds.

The record, unfortunately, proves no such thing. And no one knows that record better than Philip Tetlock, 54, a professor of organizational behavior at the Haas Business School at the University of California-Berkeley. Tetlock is the world’s top expert on, well, top experts. Some 25 years ago, he began an experiment to quantify the forecasting skill of political experts.

Tetlock has analyzed “not just what the experts said but how they thought: how quickly they embraced contrary evidence, for example, or reacted when they were wrong. And wrong they usually were, barely beating out a random forecast generator.”

Why did so many experts miss the economic crash?

The people intimately involved in packaging [financial derivatives like] CDOs must have had some sense that they were unstable. But their superiors seem to have been lulled into complacency, partly because they were making a lot of money very fast and had no motivation to look closer. So greed played a role.

But hubris may have played a bigger one. … In this case the biggest source of hubris was the mathematical models that claimed you could turn iffy loans into investment-grade securities. The models rested on a misplaced faith in the law of large numbers and on wildly miscalculated estimates of the likelihood of a national collapse in real estate. But mathematics has a certain mystique. People get intimidated by it, and no one challenged the models.

Money has written about human mental quirks that lead ordinary folks to make investing mistakes. Do the same lapses affect experts’ judgment?

Of course. Like all of us, experts go wrong when they try to fit simple models to complex situations. (“It’s the Great Depression all over again!”) They go wrong when they leap to judgment or are too slow to change their minds in the face of contrary evidence.

An Alternative to Finding a Better Forecaster

A good part of the article explores the question “What makes some forecasters better than others?” Professor Tetlock has a detailed answer, which makes interesting reading. He recommends looking for “self-critical, eclectic thinkers who were willing to update their beliefs when faced with contrary evidence, were doubtful of grand schemes and were rather modest about their predictive ability.”

But my answer to the same question is radically different. I believe that it is futile to rely on gurus who have been right more often than others. Various “experts” will be right or wrong at different times, and you cannot, regrettably, know in advance when that will be. So if in essence, the future is unknowable, and experts are so unreliable, you need to have a strategy that does not depend on “accurate” forecasts.

No one, yes no one, knows how markets will behave in the short term. Accordingly, my recommended approach has been and continues to be a disciplined long-term strategy. To understand why, it is absolutely necessary to have perspective on financial history:

• There have been many financial crises in the past; none have proven fatal.
• We have experienced a dozen other Bear Markets since World War II.
• Stock prices have rebounded from all previous declines, even steep ones.
• The stock market goes up in roughly 3 out of every 4 years.
• Stock market losses are temporary; stock market gains are permanent.

Furthermore, waiting for the “right time” to invest doesn’t work for most people, most of the time. The likelihood is that you will miss out on the really strong rebounds that happen when you least expect them. In other words, don’t wait until it looks safe to invest in stocks.

Accordingly, I leave forecasting to the “experts” who according to Professor Tetloc “barely beat random guesses – the statistical equivalent of a dart-throwing chimp – and proved no better than predictions of reasonably well-read nonexperts.”

I do believe in controlling what I can:

• Costs (through low cost mutual funds)
• Risk (through global diversification and sensible asset allocation).

I believe in staying the course so as to participate in the eventual and inevitable recovery.

In short, I do not have a forecast; I have a philosophy and an approach. It’s not perfect, nothing in this world is, but experience shows that it works better than any other approach.

“Something that everyone knows isn’t worth knowing.” – Bernard Baruch. 

Baruch was referring to individual stocks, but I take his meaning to include the economy and “the stock market” as a whole. If something is already known, it will have no further influence on individual stocks or the stock market. It is only something new that will affect prices.

Larry Swedroe is the co-author of The Only Guide to Alternative Investments You’ll Ever Need.

In a recent interview with HardAssetsInvestor.com, he talked about commodities, portfolio construction and investing strategy. He also related his outlook for the U.S. economy as a whole to his view on future returns in the stock market. Surprisingly, he is optimistic.

I know, firsthand, that a great many investors are discouraged and/or disgusted with the downturn in the economy, in general, and the decline in the markets, specifically, over the past months. Some investors have fled the stock market for safer investments. And, yes, I realize that it is difficult to find any silver lining in the current dark clouds of the economy.

Certainly, the volatility of the stock market cannot make anyone feel peaceful. It’s clear that optimism is in short supply.

Nevertheless, Swedroe thinks this may be a good time to invest in stocks. Please, consider his logic, which I personally find very persuasive.

HardAssetsInvestor.com: What are your general thoughts about the economy and the stock market here?

Swedroe: The big picture is simply this: Clearly, this is the worst economic crisis we’ve seen since the Great Depression. But wait … did I tell you anything you didn’t already know? The markets know that too. This is the worst market since the Great Depression.

We all know the economic news is going to get worse. Unemployment is going to go up; retail sales are going to go down. But while everyone’s focusing on the bad economic news, they’re forgetting that the market has already understood this.

People are saying, why can’t this be another Great Depression? And it could; you can’t rule that out. But what people fail to understand is this: In the Great Depression, the policy responses were all in the wrong direction. We raised taxes and raised interest rates, increased margin and reserve requirements, and started a trade war. The policy responses this time, whether you agree with them or not, have not only been in the right direction – cutting interest rates, flooding the markets with liquidity, etc. – but they have been the most massive effort ever.

The effort is coordinated around the globe, and countries are pledging to maintain free trade. Every major country is enacting fiscal stimulus programs, all the central banks are cutting interest rates, etc. So while we have had a massive economic crisis, offsetting that are the largest policy responses in history coordinated around the globe. Policy responses take a while to work through the system, while the economic news will continue to look bad for a while.

Remember: Just when things look darkest, stocks tend to have good returns. Prior to this year, when consumer confidence has fallen below 50, the average return for stocks the next year was 16%.

Or consider this: When the unemployment rate is below 4.3%, the average return to stocks is 2%. When the unemployment rate is over 6%, the average return to stocks is 15%.

In the 11 recessions in the post-war era, the cumulative return to stocks is up 7%, and T-bills are up 5%. Returns were positive and better than the risk-free rate. Every time an investor sold stocks and paid taxes, they would have been better off sitting pat in stocks. The only way to do better would have been to forecast the recession, and who can do that?

I cannot guarantee that we will get out of this crisis, but we have gotten out of every other crisis quite well.

(Emphasis added)

Conclusion

Certainly, there is no shortage of bad economic news: Home prices are falling, unemployment is rising, the stock market has had one of its worst years on record, and the automobile industry is asking the federal government for bailouts, like the financial services industry before them. Where will it all end? Is there any good news?

Indeed. Unfortunately, we do not know when the good news will arrive. But, what we do know is that whatever negative that can be said about the economy is already known. If it is widely known, then the bad news is already reflected in current stock prices.

If history has any relevance, and I think it does, after a stock market decline, when pessimism is commonplace, is a very good time to expect stocks to have higher returns.

This may be counterintuitive, but it is true, historically.

“If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.” – Gregory Mankiw.

The economy is in recession, and some question if the Federal Reserve Board can use monetary policy to avoid a steep decline. Therefore, I think we will all need to reacquaint ourselves with Keynesian economics.

Gregory Mankiw is a professor of economics at Harvard University. His op-ed piece What Would Keynes Have Done? in today’s New York Times is a good summary and review of Keynesian economics and how it applies today.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

To read more, click here.

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An article in today’s edition of USA Today, Bear Market Swipes at More Than Just Stocks by Matt Krantz, spells out just how bad the markets have been this year. Here is a summary:

Following a 445-point slide to 7552 Thursday, the Dow Jones industrial average is down more than 6,600 points from its high. The broad stock market is at it lowest level in 11½ years, with the Standard & Poor’s 500 index off 52% from its high in October 2007 and on pace for its worst year ever, S&P says. Only 13 of its 500 stocks are not down for the year, and more than 100 trade for less than $10 a share.

The pain extends far beyond stocks. Oil has crashed 66% from its record close in early July. Even the so-called safe harbor of gold is down 25.5% from its high in March.

This bear has trashed nearly every investment strategy and asset class. It has humbled some of the most powerful names in the stock market and blown holes through long-held tenets in investing. Market historians strain to think of previous bear markets that have disproved so many investing philosophies at the same time.

“There is nowhere to run and hide,” says Ken Winans of investment management firm Winans International. “You have gotten bludgeoned in every direction.”

The extent of the earth that’s been scorched is breathtaking. Brand-name investors such as Warren Buffett, Carl Icahn and T. Boone Pickens have suffered massive losses. Do-no-wrong mutual fund managers, such as Legg Mason’s Bill Miller, are down big. Hedge funds run by managers once thought to be infallible are having their worst years ever.

Even investors who saw the bear coming have been mauled. Those that rushed into commodities or foreign currencies to sit out problems with the U.S. economy have suffered massive losses.

The pros are struggling

Even investors who’ve sought professional help have been stung. Money poured into mutual funds, hedge funds and private-equity firms run by experts known for out-foxing markets in good times and bad. The bear has proved to be smarter than the fox.

Legg Mason’s Value fund (LMVTX), famous for the longest streak beating the S&P 500 under the leadership of portfolio manager Miller, is struggling. It is down more than 65% this year, the third year in a row that it has lagged behind the market. It now has just a one-star rating, out of a possible five, from Morningstar.

Eddie Lampert, the hedge fund manager for celebrities such as David Geffen and Michael Dell who was routinely compared with Warren Buffett just a few years ago, has seen his investments sour. His personal worth has fallen to $2 billion from $4.5 billion just two years ago, Forbes says. His hedge funds’ biggest investment, Sears Holdings (SHLD), has collapsed 70.5% this year.

Speaking of Buffett, the bear snagged the Oracle of Omaha, too. … Buffett’s personal worth is getting mauled, too. Forbes estimated his net worth at $62 billion in February, but that is based mostly on his large holdings of Berkshire Hathaway stock, which is now down $74,150, or 49%, from its high of $151,650 a share.

Commodities aren’t shelter

Investors who thought they saw the stock crash coming figured they had the answer: commodities. Fears of inflation and economic problems pushed many investors into gold. An ounce of gold soared 53.6% in the year leading up to its peak on March 18 as investors poured in. But investors who piled into gold in March have been dealt a 25.5% loss.

A similar story with oil. The price of crude was soaring earlier this year, and gas prices were a national fixation. At the closing peak of $145.29 a barrel on July 3, crude was up 51% for the year. With predictions of it hitting $200 or more, it seemed like a can’t-lose proposition. Speculators lost and lost big as the price crashed nearly $100 a barrel to about $49 now.

The Reuters/Jefferies CRB index of 19 raw materials dropped more than 4% Thursday, hitting its lowest level since April 29, 2003, according to Bloomberg News.

Global diversification is making things worse

We’ve heard it before. Own both U.S. and foreign stocks, and your portfolio’s ups and downs will be moderated. When domestic stocks zig, foreign stocks are supposed to zag.
But that hasn’t worked either. The iShares MSCI EAFE index fund (EFA), which tracks stocks in developed nations in Europe, Asia and the Far East is down 54.5% this year. That’s worse than U.S. stocks’ decline.

What about emerging markets stocks? Up-and-coming nations such as China, Brazil and India were supposed to be growing fast independent of the U.S. Well, the iShares MSCI Emerging Markets (EEM) index has fared worse, tanking 64%. Every major nation’s stock market is down this year, says S&P’s Capital IQ.

Buy-and-hold investors are getting hurt

Buy-and-hold investors know short-term swings are normal. They hold through tough times, knowing returns come to those who wait. But investors who invested in the S&P 500 10 years ago have seen the value of their stocks decline 35%. Even investors who used dollar-cost averaging and invested $500 a month starting Dec. 31, 1996, and reinvested dividends lost $13,225, or 17%, as of Oct. 31, says Winans.

Bonds are eating away at portfolios

Rather than buffering losses on stocks, corporate bonds are falling apart. The iShares iBoxx Investment Grade Corporate Bond fund (LQD), which invests in bonds with high credit ratings, has a negative return of 14.4% this year. That may not sound that bad, except investors buy bonds because they want very little volatility.

Sam Stovall of S&P says that it’s usually not wise to give up on investing in the depths of a bear market. While it takes five years on average for investors to get their money back after a 40%-plus decline, those who keep investing when stocks are cheaper are made whole faster.

Conclusion

A small point: The article overstates the damage to bond investments. Not all have suffered. In fact, Treasury securities have done quite well this year, as investors have fled to these very safe investments. (As the yield of a bond goes down, the price of the bond goes up.)

But the article is generally correct. Unless the stock market recovers from these low levels, which certainly could still happen, 2008 will go down in history as the worst year ever, as measured by the Standard and Poor’s 500 Index. I believe, though, that this is not the time to get discouraged and abandon your well thought out portfolio. In this instance, doing nothing is preferable to selling everything.

There are some opportunities out there. If you can do it, this is a good time to convert your traditional IRA to a Roth IRA. It might also be a good time to rebalance your portfolio. For more information on these two issues, you should consult your financial advisor.

Going forward, we all must re-examine our actual risk tolerance. When times are good, it’s easy to tell yourself that you can weather the (hopefully) temporary storms of declining stock markets. This year certainly proves that living through a substantial bear market, in real time, is another matter entirely.

Finally, if you are so worried about the stock market that you are having trouble sleeping, consider scaling back your equity allocation. That way you will still maintain some exposure to stocks, rather than making an emotional decision to “sell everything.”

photo credit: lexdennphotography

I tend to read market commentaries with a jaundiced eye. That’s because the authors generally restate the obvious, i.e. what has already happened, or they attempt to predict the future, which is simply impossible.

The Stock Market is Not in “Uncharted Territory,” the November 17th Market Commentary by John P. Hussman is an exception. Rather than make definitive predictions, he outlines his strategy by putting the stock market and the economy in historical perspective. Here are some quotes I like:

Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are “uncharted territory.” Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions.

Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows.

No thoughtful investor “calls a bottom” in the markets. Stocks are undervalued here, but they could decline further. Economic conditions are poor, but may be over or under-reflected in stock prices. Investors will find out over time, and the ebb-and-flow of information is slow enough to allow very large market fluctuations in the meantime.

Recent market conditions seem like they have no precedent only because so many investment professionals know only the data they’ve lived through. If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives. At this point, further declines in stock prices simply increase the long-term returns that investors can expect over time. We can’t rule out the possibility that investors could get more frightened, or that they might abandon their stocks at prices that would offer extremely high long-term returns to the buyers. It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all.

The main damage that investors can do to their financial security at this point would come from selling into steep but impermanent declines.

As a side note, do your best to filter out comments like “investors are moving out of stocks and into …” or “investors are selling into this decline” or “investors are buying into this rally.” On balance, investors do not sell shares, and they don’t buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the “market” consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you’re at a poker table and you don’t know who the patsy is, you’re the patsy.

Conclusion

No one knows or can accurately predict where stock prices are heading in the short term. It is true that if we have another Great Depression, stock prices will decline further. It is also true that after the steep decline (which we have already experienced, and which is not unprecedented) future returns are likely to be higher, not lower.

In the long term, investors are compensated for taking risks. Consequently, it is highly unlikely that, over the long term, safe investments will have higher returns than equities.

Timing the “market bottom” is impossible, but selling stocks now will most likely result in regrets later.

photo credit: erin MC hammer

Of late, I have been writing about the possibility that the current stock market decline could end with a great big bang, followed shortly thereafter by investor disgust and despondency. It’s more of an intellectual exercise, because I am basically an agnostic on the subject. Frankly, no one really knows whether or not we will have such a “selling climax.”

Jason Zweig’s Intelligent Investor post on October 25 is called Capitulation: When the Market Throws in the Towel. Surprisingly, Bear Markets Don’t Always End With a Bang — Sometimes It’s Just a Whimper. His point of view is worth reading and emphasizes that we just never know what will happen.

There’s a belief that the market can hit bottom only when vast numbers of investors finally capitulate, throwing in the towel and selling off the last of their stock portfolios. In theory, if you could spot this moment, you could make a killing buying at the bottom.

There are two problems here. First, capitulation is almost impossible to define. Second, even if you could get a positive ID on capitulation, that might not do you any good. Market lows aren’t necessarily marked by tidal waves of frantic selling; just as frequently, stocks bottom out in a dull and lonely atmosphere as trading dries up and most investors no longer even care. Bear markets often end not in capitulation but stupefaction.

Oddly, even market pundits who believe in capitulation admit they can’t define it. “Capitulation is a state of mind, without any specific definition,” says Al Goldman, chief market strategist for Wachovia Securities. “You can’t measure it; it’s best identified in hindsight.” Hugh A. Johnson, chief investment officer at Johnson Illington Advisors, says almost wistfully: “I wish I could quantify it for you so I could say, ‘Here, this is capitulation.’ But a lot of this is anecdotal. Talk to enough investors and you get an idea of whether we have capitulation.”

“The most interesting thing about [the 1974 market bottom] was its dullness,” veteran fund manager Ralph Wanger recalled to me. “It wasn’t a crash, it was a mudslide. You came in, watched the market go down a few points and went home. The next day you went through the same thing all over again.” And then, without a moment’s warning, the bull woke up and took off. By Jan. 6, 1975, the market had shot up 10%, and a year after that the Dow had risen 54% from its 1974 low.

In short, bear markets sometimes end with a bang, sometimes with a whimper. You’re more likely to see a unicorn in your backyard or a chimera in your kitchen than you are to spot an indisputable sign of market capitulation.

Conclusion

The obsessive attention so many investors are paying to the huge swings in the Dow suggests that we may not have hit bottom yet; stupefaction seems not to have set in yet. What we can be quite certain of, however, is that stock markets around the world are already on sale. If you have cash to spare, put some to work. If you don’t, save up until you do. But don’t kid yourself into thinking that you will ever get a clear signal out of such an unclear indicator.

I sincerely hope that my posts have not added to the “obsessive attention” to the stock market swings. I believe that when an investor owns, even a single share of stock, he actually owns a share in a business. A share of stock is not like a lottery ticket, and it’s more than just a piece of paper based on numbers that crawl across the bottom of a TV screen.

As providers of capital, investors are entitled to a return. In the short term, returns can vary tremendously. Historically, over the long term, stocks have returned more than safer investments.

As for the short term, i.e. what we are living through now, there are dramatic factors that have been causing stock prices to decline – specifically, margin calls and hedge fund redemptions.

An example of a margin call is a company’s CEO who had earlier borrowed money to exercise company stock options. Because the company’s stock price has since declined in value, the CEO must either put up more capital or sell the stock in the account to meet the broker’s margin requirement.

Hedge funds have been selling stocks, currencies, commodities – basically whatever they could sell – to prepare for imminent redemptions. This is, in effect, “forced selling,” similar to margin calls. And there is just no way to know when this will all end.

Since everyone knows this, it is possible that stock prices already reflect the negative situation. If that’s the case, this could be a great “buying opportunity” for stocks. Unfortunately, we will only know if we were right in retrospect.

photo credit: erin MC hammer

“These types of forecasts are wildly off-base. What they’re always about is extrapolation. People are always extrapolating recent trends. And you don’t know how far the trend is going to really run.” – William A. Fleckenstein.

This post is a continuation of articles on how no one can predict the stock market or any other market, for that matter.

Going for the Gold in Gloom and Doom by Michael M. Grynbaum has an analysis of the phenomenon of people who make predcitions that are extreme.  They not only confidently assert their forecasts, but they are frequently wrong.  And they are not held accountable for their mistakes.

“Financial forecasters are in a race to call the bottom to the bear market. And just as on the way up, when analysts competed for attention with their forecasts of bigger and bigger gains, the financial pundit class now seems compelled to out-gloom the next guy.

“To make a crazy forecast today is not crazy,” said Owen Lamont, a former professor at Yale who has studied economic forecasting. “It’s not crazy to predict the Dow is going to 2,000. That’s in the realm of possibility.”

“Even in normal times, forecasters have a strong incentive to make extreme predictions, which is why those “Dow 1,000!” reports persist. “It’s eye-popping. It’s relevant. It seems exciting,” Mr. Lamont said. Such predictions attract publicity, name recognition and a bigger client base in a business where investors pay thousands, if not millions, for stock advice and investment guidance.

And even if a forecast is off-base, there are few repercussions because they are almost always quickly forgotten. “The reason that people do these games is because no one’s really tracking accuracy,” said Mr. Lamont, who now works at DKR Capital, a hedge fund in Greenwich, Conn. “No one is carefully, prudently giving more business to the guy who is 2 percent more accurate than the next guy.”

Some say this is a system that propagates ignorance and poor advice.

“Anyone that invests 10 cents on the basis of someone’s forecast of the Dow is desirous of losing a good portion of their 10 cents,” said William A. Fleckenstein, president of Fleckenstein Capital, a money management firm in Issaquah, Wash. “It is almost the height of arrogance to say this is where the Dow is going to trade.”

“These types of forecasts are wildly off-base,” Mr. Fleckenstein said. “What they’re always about is extrapolation. People are always extrapolating recent trends. And you don’t know how far the trend is going to really run.”

Some financial pundits, however, are all too happy to broadcast their predictions to the public, no matter how apocalyptic.

Peter Schiff, the president of Euro Pacific Capital in Darien, Conn., and a prominent financial Cassandra, has seen some of his most dire forecasts confirmed amid this year’s turmoil. On Friday, he predicted plenty more pain to come.

Forecasters who get too far ahead of themselves would do well to remember an instance of notoriously poor prognostication. One of the few times that a financial strategist has been widely taken to task came in 1999, when Kevin A. Hassett and James K. Glassman published “Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market.”

The book, which arrived just months before the technology bubble burst and stocks plummeted to earth, was actually an argument that bonds and stocks should be considered as equally risky investments. But the title — cartoonish in hindsight and, in its authors’ defense, proposed by the publisher — has since become a popular punch line for jokes about irrational exuberance in turn-of-the-century Wall Street. (The Dow closed on Friday at 8,378.95).

Still, while the reputation of its authors may have taken a hit, “Dow 36,000” has not seemed to hurt their careers.

If you had taken their book seriously, you would be much poorer.  But while their predictions were way off the mark, both authors have done just fine.  One has a prestigious position with the American Enterprise Institute and one with the Bush Administration. 

Conclusion

Wildly optimistic forecasts and wildly pessimistic predictions are often wrong. Frequently the prognosticators are merely extrapolating the recent past. The main thing they accomplish is to gain attention for themselves. If you listen to such predictions and act on them, you do so at your own risk.

In a previous post, I raised the possibility that we might witness a kind of panic selling called capitulation. This was not meant to be a prediction. It was an observation that sometimes a bear market ends in a very sharp decline, and it is generally associated with investors’ extreme discouragement and/or disgust. This is not an exact science, but more like Justice Potter Stewart’s comment on pornography – you’ll know it when you see it.

Well at 7:30 this morning, the futures markets indicate a very weak opening for U.S. stocks. This is happening after markets had steep declines in Asia, with the Japanese stock market falling almost 10%. European stocks have also declined by 7-10%. Right now it looks like we are going to have a “Terrible, Horrible, No Good, Very Bad Day.” (Judith Viorst) Of course, no one knows where the market will close today or what will happen next week.

For more context, Mark Hulbert’s column Anatomy of a Bottom, written for MarketWatch on October 21st, describes the difference between a “Panic” and “Capitulation.”

Capitulation has a number of distinguishing psychological characteristics, such as investor disgust and exhaustion. Having been burned by the market for so long, investors capitulate by resolving never, ever, to trust the market again.

In the wake of capitulation, therefore, interest in the market declines. Apathy rules.

To be sure, this definition cannot be mechanically measured. It is hard to pinpoint when investors become maximally dejected and apathetic. But my hunch is that we have yet to experience capitulation.

One illustration of capitulation that I find particularly instructive, even though it is from a pre-Internet era: During bull markets, as well as during bear markets up until capitulation finally occurs, investors turn to the business sections of their morning newspapers to see how much they made or lost the previous day. At times of capitulation, in contrast, investors don’t even bother to open the business section at all.

From the perspective of this illustration as well, capitulation is yet to occur: Far from being ignored, business news is now splashed all over the front pages of newspapers’ lead sections.

My guess is that, when that low does finally occur, we’ll be witnessing, and experiencing ourselves, a lot more of the psychological traits associated with capitulation: Exhaustion, disgust, lack of interest, even apathy.

Interpretation and Advice

Investors, by definition, are “in it for the long run.” If the recent events on Wall Street, and indeed, across the globe, have you so discouraged that you question whether stocks really do provide higher returns than bank CDs, then you are in the grips of capitulation. How you behave or how you react, at this moment, will be what determines your rate of return for a long time to come.

If you sell when everyone else is selling, you may get some immediate psychological comfort that you have come in out of the storm. My belief, which is based on extensive experience, is that you will do yourself harm in the long run.

What happens to stock prices in the short term is anyone’s guess, but if investors are not rewarded for taking risk by investing in stocks, capitalism cannot function.

photo credit: JdeePanIII