Soothsayers and Monkey Brains.

January 11, 2016

January's have been historically prophetic in determining the market's path for the year ahead. Making last week's carnage particularly difficult to swallow.
Markets defied a decade-long pattern, denying investors a December rally and ending the year on a sour note. Adding insult to injury, stocks opened 2016 with one of their worst ever first-week performances. Unnerving global investors.
Understandably so.
Since 2009, the investor class has never truly believed the economy has recovered. Too many friends, family and neighbors working restaurant jobs. Too few millennials buying homes. Too few pay raises translating to too little wage growth. Accordingly, even as D.C. proselytized that the economy was on track, Main Street never got the vibe. Boots-on-the-ground evidence said otherwise.
Today, investors yet again feel the earth trembling beneath their feet. Though nothing has really changed.
The S&P 500 finds itself, for the sixth time in 20 months, approaching the low end of a trading range, roughly 1,867 - 1,880. The high end? About 2,030.
Until the index drops beneath the low end and holds, nothing has changed.
As difficult as things feel, investors harm themselves only if they lock in losses by selling. Preventing the index an opportunity to bounce off the lower end of its range and head higher for the seventh time in 20 months.
Patience, dear investor, is a virtue. Of course, so is vigilance.
As discussed in last week's missive, investors must have a plan in place for such periods. A road map that permits a portfolio to draft in the wake of rising markets. Or bail in the event of precipitous declines. Because today's market could go either way.
Of course, it was Mike Tyson who observed that 'everyone has a plan 'till they get punched in the mouth.' And the last two weeks have felt like a roundhouse to the grill. Which, if you buy into the idea that January serves as a barometer for the rest of the year, depresses the most wide-eyed optimists.
Can that be possible? We've seen the Wall Street forecasts. They're fantastic!
Therein lay the rub.
Confusing investors every bit as much as the cacophony of current events and media noise are the myriad of available market forecasts . Most of which -- at least those emanating from Wall Street -- predict positive returns every year.
In fact, I can't recall when a major Wall Street's brokerage forecast a bad year.
The Motley Fool's Morgan Housel denigrated Wall Street's forecasting record in an article last February (here). Rightfully so. While Wall Street consistently releases bold annual forecasts, the only aspect more predictable than the forecast's releases are the inaccuracies therein.
As the following chart reveals, Wall Street's consensus S&P 500 forecast versus the S&P 500's actual performance from 2000-2014 is more Mayan Calendar than Nate Silver.
A quick glance and one discerns that Wall Street's experts (blue bars) forecast 15 straight positive years. Unique only in the magnitude of each year's anticipated returns.
Yet, real life is not a linear event.
In fact, the century began with three consecutive down years. Then five winning years. Followed by 2008's catastrophe.
Remarkably, Wall Street's forecasters paid no attention to such failed estimates. Nor any actual estimates at all. After a bad year, they'd forecast a recovery. After a good year, they'd forecast more of the same. The one consistency being that Wall Street believed markets would rise year after year.
Of course, Wall Street's maximum fees occur when Main Street is fully invested in the capital markets. The real story? That Main Street continues to bestow any credibility to Wall Street at all.
A point made all the more emphatically by Mr. Housel who calculated that the forecasts of Wall Street's top strategists missed reality by an average 14.7 percentage points per year.
"Of course these are my deepest convictions and best ideas, Mr. Client. My track record speaks for itself. I usually only miss the market's actual returns by 15 percent annually."
So raising innumerable questions. Among them, "Why would investors listen to forecasters who have been so consistently wrong?"
Economist John Mauldin thinks he knows why.
Mauldin theorizes that investors want to think of finance as science. Like physics or engineering. They wish to believe it can be measured cleanly and precisely.
Accordingly, if you equate finance to physics, you might assume there are smart people out there who can read some data, crunch some numbers, and predict where the S&P 500 will be at year end. Like "a physicist can tell us exactly how bright the moon will be on the last day of the year."
Finance, however, isn't physics. It is, Mauldin explains, "much closer to sociology. Barely a science. Driven by irrational, uninformed, emotional, vengeful, gullible, and hormonal human brains."
Still, investors want to believe that certainty is possible, that crunching the numbers or listening to the right guru can reveal the future. The idea that markets are inherently messy and disorderly frightens them. Much more comforting to think that someone out there has a crystal ball.
Moreover, investors simply like to reward their confirmation biases. And so have much to gain when "Wall Street's Wizards" confirm that the coming year will, of course, provide yet another opportunity for big returns.
Which doesn't help in years like 2000, 2001, 2002 or 2008. When Wall Street's Wizards forecast -- you guessed it -- big gains.
Investors hold a narrative in their heads. A set of facts and beliefs that helps to make sense of the world. The simpler, the better. And the more confident they'll be in their investment decisions. Wall Street's pathologically positive forecasts stroke investor's confirmation biases. Serving to keep them invested in Wall Street's beloved mutual funds and money managers.
But, when an investor's simple narrative is refuted by new facts, a shock to the system occurs. That sense of control and confidence is shattered. And a fear of the unknown grabs the investor's psyche.
That being why the human brain, adapted to the plight of escaping large predators on the plains of Sub-Saharan Africa, has not yet evolved to meet the challenges of investing.
The brain is an elegantly adaptive mechanism that tunes out gradual change. Downshifting comfortably as expected outcomes occur and familiar patterns repeat. Sudden and unexpected changes, however, set off alarm bells.
Such responses are a byproduct of specialized cells in the anterior cingulate cortex that quickly respond to unexpected events. Firing warning signals to other parts of the brain that control pulse, blood pressure and stress hormones. All of which serves to immediately place the body on high alert.
That in mind, one understands how the collective mood of investors can shift so quickly. Having done so since markets began in the early 1700s. Stocks would rise together and then collectively crash. A pattern that still repeats today whenever the anterior cingulate cortex shouts "danger!" to the rest of our monkey brains. So triggering the "fight or flight mechanism."
Proving yet again that the herd response is much more adapted to the appearance of alpha predators on the Sub Saharan Plains, as opposed to preserving capital when markets decline.
Nor do Wall Street's absurdly optimistic annual positive help our monkey brains acclimate to the realities of a fluid and often volatile marketplace.
Another hundred years? Perhaps we'll be more acclimated to the rigors of investing. Till then, the myriad and disparate prophecies of so many soothsayers simply overwhelm our monkey brains. So causing the litany of mistakes to which investors, and their caveman lineages, have been prone since the last extinction event. Be that the ice age, or the credit crisis.

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