What was your reaction upon hearing from billionaire investor Stanley Druckenmiller that “we are in deep trouble”?
You probably felt like running for the hills. Druckenmiller is widely reported to have produced a 30-year return in excess of 30% a year while never having a down year. He told CNBC’s Delivering Alpha Investor Summit this week that not only will there be a hard landing into a recession in 2023, the stock market will be flat for an entire decade.
But wait! Goldman Sachs in September announced that, in its opinion, recession risks are overblown. The firm is predicting that both the U.S. and China will avoid a recession.
Which of these predictions should you pay attention to?
While you’re contemplating that question, consider interest rates. Bridgewater Associates founder Ray Dalio said at MarketWatch’s recent “Best New Ideas in Money” festival that interest rates are headed much higher, with bond prices correspondingly headed much lower. Yet Jeffrey Gundlach, CEO of DoubleLine Capital, said in a recent Twitter Spaces conversation that “bonds are wickedly cheap.”
Need I mention that both Dalio and Gundlach are billionaires with impressive track records?
Welcome to the bewildering world of “macro” forecasting. It is filled with countless “experts” making confident predictions about the future economy and geopolitical situation, only some — a minority — of which will turn out to be true. Yet, no matter how wrong their predictions turn out to be, these experts’ continue making such predictions.
And we keep listening.
We should instead be taking macro predictions with a very large grain of salt.
Why macro forecasting is often wrong
A recent Howard Marks essay provides one of the best bill of particulars I’ve ever read for why we should be skeptical of macro predictions, and I urge you to read it in its entirety. Marks is the founder of Oaktree Capital Management; his periodic commentaries, known as memos, are widely read on Wall Street. Warren Buffett, for example, once said that “when I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something.”
Marks’ most recent memo is titled “The Illusion of Knowledge.” One of the more compelling of his arguments is based on the dismal performance of “macro” hedge funds, whose strategies are based on their managers’ macro forecasts.
Those funds earn some of the highest fees in the money management industry, typically 2% of assets under management and 20% of profits. Their managers are some of the brightest and best-educated of any on Wall Street. If successful macro forecasting were possible, not just once in a blue moon but regularly, then you’d expect these hedge funds to produce impressive returns.
They don’t, on average, as you can see from the accompanying chart, which is an updated version of a table Marks included in his memo. In fact, the average macro hedge fund does significantly worse than a composite of all hedge funds, and even worse still relative to the S&P 500 SPX, -1.51%.
Marks asks: “Where are the people who’ve gotten famous (and rich) by profiting from macro views? I certainly don’t know everyone in the investment world, but among the people I do know or am aware of, there are only a few highly successful ‘macro investors.’ When the number of instances of something is tiny, it’s an indication, as my mother used to say, that they’re ‘the exceptions that prove the rule.’ ”
Why is macro forecasting so difficult? Marks argues that it’s a matter of simple probabilities. He asks us to consider the following simplified rendition of the thought process that a money manager goes through when investing in a stock: “I predict the economy will do A. If A happens, interest rates should do B. With interest rates of B, the stock market should do C. Under that environment, the best performing sector should be D, and stock E should rise the most.”
Even if this manager is right two-thirds of the time, Marks points out, which would be rare and impressive in its own right, there still would be just a 13% probability that this stock would perform as expected. That’s because the five predictions underlying the bet are dependent on each other; multiplying two-thirds by itself five times is just 13%.
And even this simplified example is too generous to macro forecasters. That’s because “a real simulation of the U.S. economy would have to deal with billions of interactions or nodes, including interactions with suppliers, customers, and other market participants around the globe. … How can a model of an economy be comprehensive enough to deal with things that haven’t been seen before, or haven’t been seen in modern times (meaning under comparable circumstances)? This is yet another example of why a model simply can’t replicate something as complex as an economy.”
Marks’ arguments don’t lead to nihilism. Instead, you come to realize that “you don’t have to know the future” to be a good investor. On the contrary, it is the very essence of investing to do your best in the absence of certainty about the future.
What does this look like in practice? For starters, Marks says that investors should expunge from their vocabulary seven words or phrases: “never,” “always,” “forever,” “can’t,” “won’t,” “will,” and “has to.”
Furthermore, you would want to avoid all-or-nothing bets on any macro forecast, favoring instead a series of smaller and more modest probabilistic bets. An example could be investing in those stocks that are heavily bought by corporate insiders. Your implicit bet with that approach is that insiders know more about their companies’ prospects than do outsiders, which on average over time seems like a relatively safe bet.
In closing, Marks mentioned a friend of his who had been persuaded by Marks’ arguments about the dangers of macro forecasting. “You’ve changed my life,” this friend said to Marks. “I’ve stopped making forecasts. Instead, I just tell people what’s going on today and what I see as the possible implications for the future. Life is so much better.”
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.