Home Value Investing Why the Stock Market is So Hard to Predict

Why the Stock Market is So Hard to Predict

I just finished reading Sapiens: A Brief History of Humankind by Yuval Noah Harari and I wanted to share an excerpt from the book that I thought was really interesting:

“History… cannot be predicted because it is chaotic. So many forces are at work and their interactions are so complex that extremely small variations in the strength of the forces and the way they interact produce huge differences in outcomes. Not only that, but history is what is called a “level two” chaotic system. Chaotic systems come in two shapes. Level one chaos is chaos that does not react to predictions about it. The weather, for example is a level one chaotic system. Though it is influenced by myriad factors, we can build computer models that take more and more of them into consideration, and produce better and better weather forecasts.

Level two chaos is chaos that reacts to predictions about it, and therefore can never be predicted accurately. Markets, for example, are a level two chaotic system. What will happen if we develop a computer program that forecasts with 100 per cent accuracy the price of oil tomorrow? The price of oil will immediately react to the forecast, which would subsequently fail to materialize. If the current price of oil is $90 a barrel, and the infallible computer program predicts that tomorrow it will be $100, traders will rush to buy oil so that they can profit from the predicted price rise. As a result, the price will shoot up to $100 a barrel today rather than tomorrow. Then what will happen tomorrow? Nobody knows.”

The Future is Mostly Unpredictable

It’s possible to accurately predict level one chaotic systems. As Harari writes, we can come up with more and more sophisticated computer models to produce better and better weather forecasts, because the weather doesn’t react to our predictions of it.

But it’s basically impossible to accurately predict level two chaotic systems because these systems will re-write themselves based on what is known about them. This is especially applicable to most complex systems involving humans. We’ve already seen the oil market example. Harari says that politics is also a second-order chaotic system. For example:

“Many people criticize Sovietologists for failing to predict the 1989 revolutions and castigate Middle East experts for not anticipating the Arab Spring revolutions of 2011. This is unfair. Revolutions are, by definition, unpredictable. A predictable revolution never erupts.

Why not? Imagine that it’s 2010 and some genius political scientists in cahoots with a computer wizard have developed an infallible algorithm that, incorporated into an attractive interface, can be marketed as a revolution predictor. They offer their services to President Hosni Mubarak of Egypt and, in return for a generous down payment, tell Mubarak that according to their forecasts a revolution would certainly break out in Egypt during the course of the following year.

How would Mubarak react? Most likely, he would immediately lower taxes, distribute billions of dollars in handouts to the citizenry – and also beef up his secret police force, just in case. The preemptive measures work. the year comes and goes and, surprise, there is no revolution. Mubarak demands his money back.

“Your algorithm is worthless?” he shouts at the scientists. “In the end I could have built another palace instead of giving all that money away!”

“But the reason the revolution didn’t happen is because we predicted it,” the scientists say in their defense.

“Prophets who predict things that don’t happen?” Mubarak remarks as he motions his guards to grab them. “I could have picked up a dozen of those for next to nothing in the Cairo marketplace.”

Harari’s example is like the opposite of a self-fulfilling prophecy – it’s a self-defeating prophecy. Whereas a self-fulfilling prophecy comes true just because it was predicted, a self-defeating prophecy doesn’t come true because it was predicted.

Conclusion

Warren Buffett famously does not give a lot of stock to models or predictions. As he says, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”

“Forecasts tell you a great deal about the forecaster & nothing about the future.”

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We were given a big reminder of the limitations of predictive models during the 2016 Presidential Election, during which essentially no one predicted that Trump would win.

You should keep this recent history in mind when you read news articles and hear forecasts of what GDP growth and inflation will be once Trump officially takes office. The truth is that no one really knows for sure, and Trump’s already shown numerous times that he’s full of surprises.

When it comes to making predictions about level two chaotic systems in general, models can only serve as rough guides that allow us to make somewhat educated guesses. But these guesses might not always be right.

So while predictions of level one chaotic systems (weather forecasts, engineering simulations, etc.) can be very useful when making decisions, if you’re going to use a model when you’re investing then it’s wise to be healthily skeptical of the output and to discount the results when making your analysis.

In The Intelligent Investor, Ben Graham wrote:

“The more dependent the valuation becomes on anticipations of the future – and the less it is tied to a figure demonstrated by past performance – the more vulnerable it becomes to possible miscalculation and serious error. And the less it is tied to a figure demonstrated by past performance – the more vulnerable it becomes to possible miscalculation and serious error.”

In fact, value investors look for investments with a margin of safety (which is one of the core tenets of value investing) so that an accurate prediction of the future becomes unnecessary.

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…

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