How Almost Always Being Wrong Has Changed the Wall Street Analyst
In hindsight, everyone saw the financial crisis coming. The crazy lending, the high leverage, the soaring home prices. It all made so much sense.
In reality, few did. Some saw troubles, or imbalances. But very, very few truly foresaw the magnitude of what would occur in 2008.
And the surprise of 2008 wasn't ... a surprise. Wall Street analysts and economists have missed nearly every significant market turning point for as long as anyone can remember. In an interview two years ago, Yale economist Robert Shiller told me:
In particular, if you look at the Great Depression of the 1930s, nobody forecasted that. Zero. Nobody. Now there were, of course, some guys who were saying the stock market is overpriced and it would come down, but if you look at what they said, did that mean a depression is coming? A decade-long depression? That was never said.
I have asked economic historians, give me a name of someone who predicted the depression, and it comes up zero.
The proof of how bad we are can be just sad. Economists Ron Alquist and Lutz Kilian once looked at all the fancy math models and forecasts analysts use to predict the price of oil one month, one quarter, and one year out. They found that simply assuming that whatever the price of oil is today is what it will be in the future is one of the best predictive strategies. Is it a good strategy? No. But it was better than most forecasting techniques highly paid analysts and consultants use.
In another study, Dresdner Kleinwort looked at Wall Street's predictions of interest rates over a 15-year period and compared them with what interest rates actually did in, with the advantage of hindsight. It found an almost perfect lag. If interest rates fell, Wall Street would wait six months and then predict that interest rates were about to fall. When interest rates rose, Wall Street would wait six months and then declare that interest rates were about to rise.
"Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future," the report concluded.
From 2003 to 2007, Standard & Poor's predicted that 0.12% of a certain type of mortgage bond would default. In reality, 28% did.
In 2008, analysts predicted the S&P 500 would earn $94 per share. In reality, it earned $15 per share.
In 2008, oil giant Gazprom's CEO predicted that oil would soon hit $250 a barrel. Instead, it soon hit $33.
We live in a world engulfed by predictions and forecasts. Yet very few ever stop to ask the pertinent question, "What is the evidence that we're any good at it?"
Those who have looked at it invariably come to the same answer: There is none. But we still lap predictions up, putting our faith in them to make important decisions. Philip Tetlock, a psychologist who has done more work on the science of predictions, put it best: "We need to believe we live in a predictable, controllable world, so we turn to authoritative-sounding people who promise to satisfy that need."
Here's what I want to know: How has being wrong so often changed the role of the Wall Street analyst?
I asked Liz Ann Sonders, chief investment strategist of Charles Schwab. Here's what she had to say. (A transcript follows.)
Morgan Housel: So how has the role of the Wall Street research analyst changed in the past 13 years, given the two crashes we had? Very few analysts saw it coming. Are analysts more humble today? How has their process changed?
Liz Ann Sonders: I don't know that they're necessarily more humble; in general, I think there are fewer of them. There's been a lot of consolidation in the traditional institutional equity side of the business. There are, I think, probably fewer analysts out there. A lot of the more boutique and medium-sized firms have either disappeared or been swallowed up by some of the larger firms.
We certainly don't have the unbelievably famous, big-name analysts typically as much as we did 10 or 15 years ago that through a single utterance could move a stock to a significant degree, and I think that is partly function of the fact that maybe people just aren't reacting to the analyst community as much.
We're somewhat biased, and I'm somewhat biased, sitting in a seat as someone working at Charles Schwab, because we don't have fundamental analysts that make buy and sell decisions in a traditional way. We have Schwab equity ratings; we rate over 3,000 stocks, and it's an A, B, C, D, F grading system. It's got a lot of the fundamental inputs that an individual analyst would use, but it's done a bit more quantitatively, so again, I'm speaking from the perspective of somebody at Schwab, but we certainly don't feel like to give us an edge, we need a couple of high-profile analysts touting stocks, that there's probably a better mousetrap, and we think we have one of the best in that. So yeah, I think in general the fame associated with the analyst community of the '80s and '90s is maybe not dead, but is certainly ill compared to where it was.
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