Excerpted with permission of the publisher, Wiley, from Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets by Michael Covel. Copyright (c) 2017. All rights reserved. This book is available at all booksellers.

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Al Capone famously said: “It’s a racket. Those stock market guys are crooked.”

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That’s dead on.

The crooked abound. Or, to be kind, I will call them ignorant. Or, to be nice, I will call them wrong. I often wonder if my great-great-uncle Frank Mast (Balys Mastauskas; my grandfather’s uncle) passed a little of that good-fight-attitude genetic material along.

Trend Following, 5th Edition - Holy Grails Covel

Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets by Michael Covel

The rackets found on Wall Street always overflow with Holy Grails-those predictions, secret formulas, and divine interpretations that promise otherworldly knowledge and riches. They are most often delivered in the investment world through a black box—a closed system where the inputs and outputs are known, but the internal analytical workings are left top secret, only for the high priests’ consumption.

Black box positioning goes far beyond markets. It is not surprising in a modern, interconnected age when you take a smart guy, rows of computers, proprietary formulas, and code only the one smart guy can see, and then add a string of successful forecasts, boom—you end up with a nerdy, made-for-social-media superstar who suddenly makes prediction cool for the proletariat.

Nate Silver is that it guy. Consider:

  • He successfully called the outcomes in 49 of the 50 states in the 2008 U.S. presidential election.
  • He successfully called the outcomes in 50 of the 50 states in the 2012 U.S. presidential election.

Thus, Silver became the go-to smart numbers guy overnight. He went from baseball stats expert to political stats expert. His mathematical model for elections beat political journalists and commentators at their own game—so goes his Moneyball-for-politics narrative. In short order his followers on Twitter surpassed 1 million, his book became a bestseller, and FiveThirtyEight.com became ubiquitous—even offering investing insights such as, “Worried about The Stock Market? Whatever You Do, Don’t Sell.”

Yet for anyone who followed the 2016 presidential race, Silver’s political predictions went bust. Over the course of 2016 Silver posted daily election odds that jumped around like a cat on fire—not exactly surprising

if your new guru status forces you to offer forecasts every day of an election cycle for over a year.

He admitted in his laborious mea culpa, “How I Acted Like a Pundit and Screwed Up on Donald Trump” to not using his statistical models on Donald Trump’s candidacy. He instead used educated guesses, which blew his statistical-model-made-me-famous-you-can-now-trust-I-am-not-a-typical-pundit-with-built-in-biases storyline out of the water. Worse yet, the way Silver outlined his predictions, he could say he was right no matter what happened. For Silver’s followers, his 2016 hedged forecasts, his arguable mathturbation, doesn’t matter:

“Look at Nate’s record. Trump was an outlier.”

“There was not enough historical data.”

“He gets most of them right.”

“Nate’s winning percentage is so high.”

Those weak retorts illustrate the faulty foundation in Silver’s approach: He leaves out the surprises, the unusual, and unexpected. He has no way of predicting or accounting for those. On Trump’s win, Silver said as much, “It’s the most shocking political development of my lifetime.” But no one can predict outliers, so if someone like Silver pretends he can—watch out. Spyros Makridakis, in his famed 1979 paper “Accuracy of Forecasting: An Empirical Investigation,” showed simple beats complicated and moving averages beat tortuous econometric routines. Would moving averages also have predicted the two elections that made Silver a household name?

Nonetheless, Silver defenders come back to the 49 out of 50 and 50 out of 50 in 2008 and 2012—proof, they say as they ignore 2016. But in 2008 and 2012, what percentage of those were hard calls? For example, California is blue no matter what. So there is always a huge risk in relying on strategy that gets the easy calls right and punts on the hard ones.

These are not terribly new inconsistencies to ponder. The efficient market theory—the strategy that runs the world’s money—also has no solution for surprise (i.e., black swans). Silver illustrates the conundrum across a different discipline, but with the same pressing problem. In summer 2016, Nassim Taleb, father of the black swan, launched a detailed criticism of Silver into the public sphere: “@FiveThirtyEight is showing us a textbook case on how to be totally clueless about probability yet make a business in it.”

The intellectual cage match: Nassim Taleb versus Nate Silver.

Pick your side carefully, it just got real.

About the Author:

Michael W. Covel searches. He digs. He goes behind the curtain to reveal a state of mind the system doesn't want you in.

Michael Covel teaches beginners to seasoned pros how to generate profits with straightforward and repeatable rules. He is best known for popularizing the counterintuitive and controversial trading strategy, trend following. His perspectives have garnered international acclaim and have earned him invitations with a host of organizations: China Asset Management, GIC Private Limited (Singapore), BM&F Bovespa, the Managed Funds Association, Bank of China Investment Management, the Market Technicians Association, and multiple hedge funds and mutual funds. He also has the distinction of having interviewed five Nobel Prize winners, including Daniel Kahneman and Harry Markowitz, on his Trend Following podcast—which now exceeds 500 episodes and 5 million listens. For more information, please visit https://www.trendfollowing.com/ and follow the author on Twitter