High noon for 2015 market prophets

When a prophet speaketh, … if the thing follow not, nor come to pass, … the prophet hath spoken it presumptuously: thou shalt not be afraid of him.” [Deuteronomy 18:22].

In a December 2014 Math Investor blog, we assessed how 2014 market prophets had fared (answer: not very well). Thus with the holiday season once again upon us, it is time to check scores. So how have 2015 prophets performed? Can prophets make profits?

Stock pickers lose

2015 was not a good year for stock pickers. According to Thomson Reuters and FacSet, the ten U.S. stocks that leading Wall Street analysts selected in January 2015 have lost 7% (as of 22 Dec 2015), even including dividends. What’s more, the ten stocks that were rated the lowest have actually gained 3%.

Another rough year for hedge funds

The hedge fund industry attempts to engage prophetic powers of analysis to beat the market and to reduce volatility during corrections. But they have not done very well lately. 2014 was a rough year for hedge funds, with approximately 870 funds closing their doors during the year.

However, hedge funds are faring no better this year. In fact, 2015 is on track to be the worst year since the 2008-2009 financial crisis for hedge funds. Bloomberg reports that approximately 690 funds closed their doors through September 2015, and, if closures continue at roughly the same rate, the total will be approximately 900 for the year, even worse than 2014. The third quarter of 2015 was a particularly tough one for hedge funds, with total assets dropping by USD$95 billion. Hedge funds focused on China, energy and emerging markets were hit particularly hard.

Why all the carnage? The answers are not too hard to come by. Here is a comparison of the Barclay Hedge Fund Index (BHFI) with the S&P500 index over the past five years (2015 figures as of 22 Dec 2015):

Year BHFI S&P500
2011 -5.48% 0.00%
2012 8.25% 13.41%
2013 11.12% 29.60%
2014 2.88% 11.39%
2015 0.98% 1.10%

Note that the BHFI has lagged the S&P500 index for five consecutive years, with a 5-year performance of 3.55% per year, compared with 11.1% for the S&P500.

It should also be kept in mind that most hedge funds assess a management fee, typically 2% per year (irrespective of performance) and 20% of any gains. Some investors are now asking that hedge fund managers beat benchmarks before charging fees.

Along this line, about seven years ago Warren Buffett wagered Ted Seides, a New York hedge fund manager, that money invested in a low-cost S&P500 index exchange-traded fund would beat a portfolio of hedge funds over a ten-year test period. Seven years into the bet, the S&P500 index has increased approximately 63%, whereas the portfolio of hedge funds is up only 20%.

Prophets of doom

2015 has also been a hard year for prophets of doom — even though many markets indeed suffered a correction, in most cases broad-market indices in first-world nations have largely recovered for the year. Here are some doomsaying predictions from the MarketWatch.com site (note that the author of the blog or article is not always the one making the prediction):

As we have noted before, both mild and severe corrections are the inevitable fate of all financial markets. And when a relatively severe correction arrives, numerous market prophets claim credit, pointing to some recent or not-so-recent prediction as evidence of their prescience.

But statistically speaking, what is the substance of such a prediction when it is repeated over and over again? Highlighting correct predictions, and ignoring numerous incorrect predictions, is a classic “selection bias” statistical error, one that afflicts numerous fields of modern science and technology. For example, pervasive selection bias problems in the pharmaceutical industry have led to a call for all trials, successful or not, to be made public.

Can markets be predicted?

Some doomsaying predictions are based on chart analysis (see this item and this item for example). Yet as we have emphasized before, such predictions have no scientific basis.

After all, markets by definition encapsulate the collective wisdom of tens of thousands of highly trained market analysts (many with advanced mathematical training), assisted by some of the most sophisticated mathematical algorithms and some of the most powerful supercomputers on the planet. Some hedge funds that actually make money, such as Simon’s Renaissance Fund, employ such strategies.

The net result of these competing analyses is to squeeze out any potential intelligence, leaving nothing but noise (a “random walk”) and perhaps a very low-intensity signal that relatively unsophisticated analyses have little chance of even seeing, much less profiting from. So how can someone, employing only simple-minded chart analysis, possibly predict the future, let alone confidently state that a major correction is at hand?

Let’s not be surprised when market prophets do poorly — after all, they are betting against a (nearly) random walk. One would do just as well throwing darts at a dartboard. Instead, let’s follow Jack Bogle’s advice, and place our confidence in the mathematics of patient, long-term, low-cost investing.

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