What Can We Learn from Fake Forecasting on Wall Street?

Table of Contents: Select a Link to be Taken to That Section

Executive Summary

What is the history of fake forecasting?
We cover the relationship to supply chain forecasting.

Introduction

This blog primarily focuses on supply chain forecasting. However, it is interesting occasionally to observe other areas of forecasting to learn from it. Wall Street is an exciting area to watch because the most money in business spent on forecasting is spent in financial forecasting. This industry also routines employs Ph.D. level mathematicians, which is a rarity in the industry. They can do this, of course, because Wall Street pays so well. However, what all of these people and money and systems cannot seem to do is to create forecasts that are better than coin-flipping or horoscope reading. The PhDs are mostly a smokescreen, to build credibility to cover for the fact that their projections are inaccurate. The following quotations are exciting passages from a book on forecasting called “The Forecast Sellers.” He beings by describing how anthropologists might look at Wall Street in the future.

“To a sociologist from the distant future, the efforts of Wall Street brokers and analysts to predict the stock market at the end of the twentieth century might seem comparable to the behavior of an ancient tribe. Such an observer might describe their behavior as follows: Wall Street was a tribe that inhabited the southern tip of a small island and wielded enormous influence throughout the globe. The tribe worshipped a superior life form called “The Market,” and their lives were completely consumed by contemplation about The Market’s moods, what it thought, and how it reacted to global events. They fretted over whether The Market was depressed, overexcited, acting irrational, or correcting its past mistakes. The tribe derived its power from its professed ability to answer a single question—”What’s The Market going to do?”— posed constantly by people from all over the world, who said the Wall Street tribe billions and billions of dollars to answer this question. One way or another, every member of the tribe was involved n predicting The Market.” – William A Sheriden

There are two major forecasting camps on Wall Street. One is technical analysis, which is strangely named as it is primarily chart reading, and the other is fundamental analysis, which is where things like the economic growth rate and the price-earnings ratio of the stock are looked at.

It turns out that neither method can beat pure chance, but Sheriden has a particularly amusing take on technical analysis.

“Technical analysis is doomed to fail by the statistical fact that stock prices are nearly random; the market’s patterns from the past provide no clue about its future. Not surprisingly, studies conducted by academicians at universities like MIT, Chicago, and Stanford dating as far back as the 1960s have found that the technical theories do not beat the market, especially after deducting transaction fees. It is amazing that technical analysis still exists on Wall Street. One cynical view is that technicians generate higher commissions for brokers because they recommend frequent movement in and out of the market. On this point, Malkiel commented, “The technicians do not help produce yachts for the customers, but they do help generate the trading that provides yachts for the brokers.” – William A Sheriden

Regarding being able to produce forecasts of no value continually but continue to receive paying customers, Wall Street seems to have no equal. The primary reason for this is that people need to believe that there is a way to improve the averages by buying advice. Strangely, the track records of those selling forecasts are often not checked by those buying predictions. For instance, a forecaster can have a positive return, but the overall market may be returning higher than that. The important measurement is if the forecaster can beat the average, and can consistently do this.

Fictitious and Highly Biased Forecasts

Some institutions retain their right to charge for false and highly biased forecasts even after they have been shown to have doctored their forecasts to maximize their revenues. An excellent example of this is Standard & Poor’s, which made a big splash in the news by downgrading the US Debt. However, few news outlets explained to their readers and viewers that Standard & Poor’s (along with the other rating agencies Fitch and Moody’s) had been responsible for providing the highest AAA rating to toxic assets. This allowed the corrupt carousel of mortgage-backed securities to cause the massive financial crisis of 2007/2008.

The Wall Street Journal covered the event as if Standard and Poor was some authority the creditworthiness of instruments and institutions as can be seen from this quote below:

“S&P removed for the first time the triple-A rating the U.S. has held for 70 years, saying the budget deal recently brokered in Washington didn’t do enough to address the gloomy outlook for America’s finances. It downgraded long-term U.S. debt to AA+, a score that ranks below more than a dozen governments’, including Liechtenstein’s, and on par with Belgium’s and New Zealand’s. S&P also put the new grade on “negative outlook,” meaning the U.S. has little chance of regaining the top rating in the near term.Lessons from other countries, such as Canada and Australia, suggest it can take years for a country to win back its AAA rating. At the same time, the economic impact of past downgrades has tended to be larger when multiple firms move to rate a country’s debt as riskier, as opposed to a single firm acting unilaterally.” – Wall Street Journal

Nowhere in the article is it pointed out that Standard & Poor’s had been selling doctored forecasts and ratings to the major investment banks for decades. However, a separate quote from the Center for Economic Policy Research (CEPR) did point out what was evident to people who had followed the rating agencies.

“The decision by Standard & Poor’s to downgrade U.S. government debt reflects its own failings as a credit rating agency. It says nothing about the creditworthiness of the U.S. government. Clearly the S&P downgrade was not based on the economics of the country’s debt. S&P has a horrible track record of incompetence in the housing bubble years – they gave Lehman Bros. AAA rating just before its collapse – and the accounting scandals of the stock bubble years. This downgrade should be seen in this light. It is not a serious assessment of the nation’s fiscal condition.” – CEPR

However, many more people read the Wall Street Journal article than read the CEPR article. The Wall Street Journal has a vested interest in maintaining the things as they are, and the WSJ may receive advertising revenue from the rating agencies. Secondly, the WSJ is owned by News Corp (headed by Rupert Murdoch which wanted to push for deficit reduction which meant scaring the public with false concern over the debt ceiling). This means that they have little interest in pointing out the actual performance of the rating agencies to their readers.

Therefore, Standard and Poor’s, Moody’s, and Fitch’s continue to sell wrong forecasts regardless of their track record. Interestingly, while corrupt news outlets like the WSJ and propose that Standard & Poor’s makes forecasts that are based upon something, it takes a population with zero memory to believe it.

Beating Markets

Much of the advice given out by the enormous number of financial firms selling forecasts are based on the idea of beating market averages. However, while there is a way to beat markets, the most proven method is to have access to inside information. It is, for obvious reasons, rare for inside information to be sold, as it is more profitable to act upon it. There is excellent evidence that the overall “averages” of returns of various financial markets is overestimated for the typical investor because insiders take a large portion of the total gains. Invoking an average is its form of forecast. Therefore when a standard is quoted, it also must be analyzed. Financial advisors primarily use “averages” to mislead ordinary investors as to the returns they can expect to receive.

This is called yield disparity and can be read about it in this article:

Secondly, what is often happening concerning finance forecasting is called overfitting by Michael Gilliland:

“Anyone can come up with what sounds like a reasonable explanation of past events, but investors don’t need an explanation of why the market did what it did today. Investors need someone to tell them, with a high degree of accuracy, what the market is going to do tomorrow.” – Michael Gilliland

Relationship to Supply Chain Forecasting

Wall Street is unusually thick with fake prediction, but supply chain forecasting also has some dubious methods. There are some methods such as Croston’s, which I think demonstrate limited value but are highly sought after due to the desperation that people have to find an algorithm that can predict lumpy demand. (read more about this at the link)

The Croston’s method has a lot in common with many highly mathematical models produced by Wall Street. Because the general population cannot understand highly complex models, they are assumed to be better than more simple methods. People go gaga over the unintelligible. This is one reason the Catholic Church opposed translation of the bible from Latin. Unintelligibility is a keen desire of those who seek to control others, as this following quotation describes quite well.

“A century before Galileo, the Englishman William Tyndale was so upset by the foolishness and corruption of the local clergy that he decided to circumvent them and publish a version of the Latin Vulgate Bible in plain English. The Church strongly disapproved, since this would mean that priests would lose their monopoly as interpreters of the word of God. The Archbishop of Canterbury had already declared translation of any part of the bible as heresy punishable by burning. Tyndale was trapped by an agent and arrested. He was charged as a heretic and burned at the stake.” – Dr. David Orrell

Croston’s is one example of unintelligibility, but there are certainly more in the field of supply chain demand planning.

Conclusion

While this site attempts to describe methods that do work. It is essential to occasionally recognize that forecasting in the supply chain, as with prediction in all other fields. It is also filled with methods and approaches that have been historically proven not to be an advantage, but which continue to be used because people need to believe that these methods work.

The fact that so many forecasting methods through time (astrology, crystal balls, praying to various gods, animal sacrifice), is evidence that there is a genuine human need to believe in the power of a method to tell and even in many cases control the future. There is explicit subordination to authority here, in that the concept is that other “smart guys,” can predict the future, and you can benefit if you figure out who they are.

The vast majority of the population up to modern times did not have the opportunity to become exposed to the scientific method (what is a hypothesis, how is evidence gathered, etc..). And that most of the population and most companies still do not practice structured, evidence-based approaches to determine what is useful to use to forecast and what is fake forecasting. Therefore, forecasts of extremely dubious value continue to be purchased, and most likely always will.