The Wisdom of Crowds, Year Two
Not satisfied with traditional measures of stock valuation, University of Chicago business-school graduates Rafael Resendes and Daniel Obrycki founded the Applied Finance Group (AFG – note that the author of this piece serves as an economic advisor to AFG’s mutual fund arm, Toreador Research & Trading) in 1995. Resendes and Obrycki created models showing among other things why earnings do not reflect a company's profits, why P/E ratios are poor proxies for company value, and why sales growth is not a leading indicator when it comes to rising stock prices.
Their research led them to what they call an Economic Margin Framework, which corrects the various distortions and flaws that reveal themselves with traditional "As Reported" accounting figures. Incorporating the widely accepted economic principle that competition gradually erodes excess returns over time, Resendes and Obrycki built a market-outperforming valuation metric that has attracted over 175 institutional clients managing over $350 billion in U.S. equities alone from around the world.
Each year AFG hosts a client conference in Las Vegas. As part of the proceedings, the clients in attendance fill out a survey which asks them to make various market and political projections for the year ahead. Given the relevant information that often reveals itself through the aggregated wisdom offered by crowds, it seems worthwhile to analyze some of last year predictions, all the while detailing some of what the AFG clientele foresee in the year ahead.
Last year, 47 percent of those surveyed said they were less optimistic about the equity markets going forward, 27 percent were neutral, and 24 percent were bullish. The large crowd of bears was proven somewhat correct in that year-over-year, the S&P 500 fell 10.27 percent. Of note, less than a percent surveyed last year felt a greater than 10 percent S&P correction lay ahead, but just that and more (if market turmoil from the summer is factored in) has materialized.
41 percent of the attendees felt the S&P would handily outperform the Russell 2000 in the year ahead, and while outperformance wasn’t of the 5 percent variety that was assumed, the Russell did fall 11.88 percent compared to the S&P’s aforementioned decline of 10.27 percent. With large cap stocks presumably better situated to weather economic uncertainty, the S&P projections from ’07 jibe with a clientele that was bearish in its posture.
On the oil front, 64 percent of those surveyed said oil would more likely hit $80/barrel before it touched $50, and this proved wildly corrrect. Where it gets interesting is that 72 percent said a weaker dollar would be good for stocks. This paradox was noted last year in that with oil’s price largely a function of the dollar’s direction, the twin assumptions were somewhat contradictory.
Indeed, the inflation that is a function of a weak currency is a retardant for stocks as evidenced by equity returns from 1966 to 1982. Notably, oil as mentioned does best when the dollar is weak. The dollar’s continued fall since last year has shown up in oil prices that at one point reached $145/barrel, and this has occurred alongside broad weakness in the equity markets.
In the political space, to show how quickly things change, twenty percent said Rudy Giuliani would be our next president, while 36 percent said Hillary Clinton would ascend to the Oval Office. Since these predictions were largely guided by the political punditry paid to comment on same, the faulty predictions there are perhaps an indictment of pundits who seek to crown winners before the votes are cast.
Looking at this year’s predictions, while the attendees almost overwhelmingly believe the U.S. still offers the greatest economic opportunity, there’s a decidedly bearish sentiment when it comes to the economy and the stock markets. These bearish feelings seem to be tied to projections about who will be our next president. 53 percent feel Barack Obama’s policies will be bad for the economy, and 68 percent feel he'll be our next president.
Asked to predict what will be the most significant challenges for the economy in the next twelve months, oil/energy (15.5%) and inflation (21%) got the most votes, while the credit crisis (9.5%), Democrats (9.5%) and housing (14%) rounded out the top five. And with inflation the number one risk, it’s not surprising that 50 percent of those surveyed are less bullish about stocks than they were last year.
30 percent think the S&P 500 will outperform the Russell 2000 by more than five percent this year, while another 46 percent believe the S&P will beat the Russell by less than 500 basis points. Only a fifth of those surveyed think the Russell will outperform the large cap index, so these numbers surely jibe with the generally bearish and conservative outlook held by the attendees.
And while a majority forecast a higher oil price last year, this year 67 percent think we’ll see $100 oil before it reaches $170/barrel. With oil down to $119/barrel, so far this prediction is proving correct. Either way, as in if oil moves back up above $130, 62 percent polled think the economy will continue to grow if so.
Despite a consensus view that the price of oil will decline, 55 percent of those surveyed still believe the economy will enter a recession this year. As for housing, 84 percent think troubles in that space will harm the economy. What’s unknown is why. Indeed, stocks rallied in the aftermath of an even greater moderation of home prices in the early ‘80s, so while housing’s problems are viewed as problematic, it could be that many think the interventionist governmental response to housing problems will be what hurts the economy the most.
A whopping 92 percent feel the dollar will appreciate against the euro this year, and contrary to last year’s consensus that a weak dollar would help equities, 83 percent think a stronger dollar will help the economy over the next five years. If equities are the truest barometer of our economic health, and it says here they are, this year’s sentiment suggesting a stronger dollar will aid the economy is a good one. All one need do to confirm this view is to look at the strong-dollar decades (‘50s – S&P +245%, ‘80s +121%, ‘90s +208%) since World War II versus the weak-dollar decades (‘60s – S&P +54%, ‘70s +17%, and -2% since Jan ’01) to see that economies embrace strong currencies while retreating during periods of money enervation.
73 percent of those polled think most Americans are happy, and this consensus conforms with the groundbreaking studies done by Arthur Brooks at the American Enterprise Institute. An even greater percentage believes the typical American worker is happier than his or her German/French counterparts, and this too is confirmed by Brooks’s research. Coddled workers are evidently not as happy, and who can blame them considering the higher levels of unemployment in Europe?
Given the choice to trade economic opportunities with workers in countries ranging from China to the U.K. to Brazil, heavy majorities said they would not make the trade. What fascinated this writer is that while China (17%) and India (22%) are lionized by most media for their blindingly bright economic futures, both polled behind Brazil (35%) among attendees in terms of countries they would prefer to work in.
Looking ahead to the elections, 40 percent think the country is on the right track, while 50 percent think it’s not. Importantly, 64 percent think equity prices will decrease if capital gains taxes are increased in 2009.
For those looking to position their portfolios ahead of November, 68 percent think Barack Obama will be elected president in 2009. Obama is presently of the mind to increase the capital gains levy, so investor beware. Notably, 82 percent think John McCain will be good for the economy, while only 46 percent think Obama will do a creditable job.
James Surowiecki, author of the 2005 book The Wisdom of Crowds, says "groups are remarkably intelligent, and are often smarter than the smartest people in them." Looking ahead, it will be interesting to see if Surowiecki's thesis holds when it comes to the successful investors who gathered in Las Vegas in June. Their aggregated wisdom seems to suggest that the stock market isn’t necessarily a great place to be going forward thanks to a potentially worsening policy outlook from Washington. As was written at this time last year, if the collective wisdom offered up by AFG’s clients proves accurate, investors should once again watch presidential polling to divine the future of stock-market returns.