TV personality economists, presidents, chairmen of the Fed, CEOs – they all make dumb predictions that leave them with egg on their faces. There are books full of their dumb predictions, so there's little point in repeating them here.
Okay then, just a few.
In July 2007 Ben Bernanke, then Chairman of the Federal Reserve, stated: ‘Employment should continue to expand … The global economy continues to be strong … financial markets have remained supportive of economic growth.'
Bad call. The US economy collapsed into recession five months later.
On 17 May 2007 Bernanke had said: ‘We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.'
The following year the fallout from subprime triggered the world's worst financial crisis in 80 years.
The irony is that Bernanke was a student of the 1929 Crash. And below is an extract from an editorial published in The Wall Street Journal on 3 September 1929. The Dow Jones Industrial Average had just closed at its all-time peak of 381.17:
Wall Street entered the autumn financial season in a definitely optimistic frame of mind. With railroad traffic showing steady gains, and production in the major branches of industry continuing at a high rate, the earnings prospects of the principal corporations with shares listed on the Stock Exchange were looked upon as extremely promising. Sentiment regarding the credit outlook was reassured by the activities at the Federal Reserve authorities in placing funds at the disposal of business through bill purchases in the open market. With trade and credit conditions favorable, buying orders accumulated in large volume over Labor Day, and the forward movement in the main body of stocks was vigorously resumed in the early dealings … Bullish enthusiasm was stimulated by the return of United States Steel to leadership in the industrial division.8
Like a boat full of oblivious oarsmen rowing towards Niagara Falls, there's not a single hint of imminent danger. The next month the 1929 Crash hit, and less than three years later the Dow had collapsed by 89 per cent.
At the epicentre of 2008's GFC were mortgage providers Fannie Mae and Freddie Mac. On 16 July 2008 Bernanke said that Fannie and Freddie were ‘adequately capitalized' and ‘in no danger of failing'. Just weeks later the US Treasury committed to a $200 billion bailout to save the two insolvent institutions. Financial markets and economies around the world went into a tailspin.
Okay, enough of that. If I keep going we'll be here all day. Back to a more general discussion, starting with those who believe prediction is possible – the Nostradamus set. This type of thinking is exemplified by Harry S. Dent, Jr., who states in his book The Next Great Bubble Boom: ‘Today there is an attitude that nobody can predict the future … that there are too many complex variables that can impact it. But this is obviously nonsense.'9
Could I suggest that what's obviously nonsense is the statement itself? Dent's book doesn't offer any prediction methodology, nor have his own powers of prediction been particularly impressive. For example, in 1998 he forecast the Dow would be between 35 000 and 40 000 by late 2008 or 2009. The time he chose for the peak was slap-bang in the middle of the GFC. By then the Dow had actually plummeted to a low of 6470.
The problem is that we can't deny some degree of prediction. Prediction is central to investing; it's what investors do. They invest money today predicting they'll be delivered more back in the future. So we need to explore the subject of prediction further. Let's start by looking at ‘game theory'.
GAME THEORY
I saw a documentary a few years ago called The Next Nostradamus. It featured political scientist Professor Bruce Bueno de Mesquita, from New York University. He'd developed a predictive computer program based on game theory. While Bueno de Mesquita didn't come up with the idea of game theory, his name has become closely associated with it.
Game theory is the study of strategic decision making. It aims to predict outcomes by first identifying who the big movers and shakers are in any deal. Then it identifies the outcome each player is looking for. That's relatively easy. Put yourself in their shoes: humans are driven by self-interest, so what benefits each is the outcome they're driving for. Next, assess how much influence each player brings to the table. The biggest mover and shaker has the greatest influence on the outcome. Then throw all the variables into a computer and let it spit out the answer.
But Bueno de Mesquita reckons his technique isn't applicable to all situations, the stock market being one of them. He applies it principally to the political arena. Is Iran going to produce an atomic bomb? Is the President going to be re-elected?
So if it can't be applied to stock markets, why have I mentioned it? The reason is that Bueno de Mesquita is an intelligent guy who has devoted his career to making a science out of prediction. He believes in prediction. And even he is ruling out the stock market as something that's predictable.
In February 2009 he delivered a presentation on game theory in Long Beach, California, as part of the popular TED series. He told the audience that the use of game theory didn't facilitate stock market prediction. But he immediately followed with a tongue-in-cheek stock market prediction of his own: ‘Okay, it's not going up any time soon.' He was spot on with his ‘inability to predict' comment: 12 months later the Dow was up by 21 per cent.
But in the same TED presentation Bueno de Mesquita proposed that the power base of Mahmoud Ahmadinejad, the President of Iran, was being eroded and that he would soon cease to be a force in Iranian politics. He was correct on the first point but wrong on the second. Ahmadinejad was re-elected to a second term just four months after the TED presentation. But there were cries around the world that the election was rigged – the only way Ahmadinejad could regain office. Now you could argue that the model couldn't be expected to predict foul play. But on the other side of the coin the model is based on consideration of the political influence each player brings to the game. Clearly Ahmadinejad possessed more influence than Bueno de Mesquita had dialled into his model.
While game theory presents nuances upon subtleties upon uncertainties upon judgements, Bueno de Mesquita reckons he gets a 90 per cent strike rate when using it in the appropriate arena.
One very interesting aspect of game theory is the number of potential interrelationships between the players in the game. Bueno de Mesquita explains it this way: if you're considering a problem that involves five participants, there are 120 different ways in which those five can interact. This figure is calculated by using the following factorial operation:
Factorial 5! = 5 × 4 × 3 × 2 × 1 = 120
Adding extra factors or participants sees this number expand dramatically. For example, consider 10 players. The potential number of direct interrelationships is 3.63 million. One hundred players (defined by factorial 100) is a staggering 9.33 × 10157. That's nine (and a bit) with 157 zeroes on the end!
You can start to see why game theory can't be applied to financial markets: the number of variables in the stock market is mind-boggling. There are unknown factors that impact unknown factors that impact unknown factors that impact the unknowable outcome – multiple layers of unquantifiable complexity that are impossible to imagine, let alone measure.
As if that's not enough complexity, yet another layer needs to be added. The system is dynamic. The factors and the relationships between them are forever changing. There are no constants.
Bueno de Mesquita is the first to list the limitations of game theory. He doesn't hold it out as a tool for long-term prediction under any circumstances. The players must actually be in the act of playing the game when the call is first made. I know it's a fine point, but this means he
