July 28, 2008
The news hit Wall Street trading floors on the morning of July 2: Some analyst at Merrill Lynch was saying the General Motors Corporation might go bankrupt.
Within minutes, the share price of G.M., the landmark corporation that once symbolized America’s industrial might, was plunging to its lowest point since 1954.
What the Merrill analyst actually wrote, in a downbeat report on the troubled automotive giant, was that bankruptcy for G.M. was “not impossible” — an equivocal forecast that could be applied to almost any event, from winning the lottery to the odds of rain a week from Wednesday.
But amid a financial crisis where the unthinkable has seemingly become routine, Wall Street forecasters — and even the markets themselves — are struggling to get a handle on what will happen next. The result has been a flood of brash pronouncements, as the Cassandras of the financial set try to outdo themselves with increasingly outlandish predictions.
“These are volatile times. There’s a lot of moving parts here, and nobody can quite figure out how they all mesh,” said the investment strategist Edward Yardeni. “You’re hearing a lot of catastrophic predictions.”
So far, many of these forecasts, whether computer-crunched numbers or seat-of-the-pants guesstimates, have turned out to be wrong. But investors, struggling to make sense of one of the most severe downturns in a generation, still seem to hang on to Wall Street’s every word. Forecasts that might have been dismissed a year ago are now earning serious attention and moving markets.
Some critics of forecasting say this is a dangerous trend. The events of the last year have lent credence to the case of the heretics who say that Wall Street puts too much faith in its ability to predict the future by looking at the past.
In a best-selling book, “The Black Swan,” Nassim Nicholas Taleb, a former trader, famously blasted economists for exploiting “our desire to be fooled by a simpler representation of the world.”
“I cannot find a single convincing argument that tells me that astrologers won’t do better than economists,” Mr. Taleb said last week by telephone from Lebanon, where he was mountain hiking.
“The problem is the arrogance of these economists,” he said. “They’re making people rely on theories that have not worked, do not work, and are really dangerous.”
Mr. Taleb pointed to the reliance of some investors on financial models, the quantitative wizardry that can churn reams of data in an instant. These were the same models that, in the lead-up to the subprime mortgage meltdown, assumed home prices would never decline on a nationwide basis. They also ran so-called stress tests on complex investments that ended up losing money when the economy went south.
But despite this decidedly mixed track record, forecasters still enjoy a rapt audience, particularly at a moment when so much in the markets depends on the uncertain course of the housing market and the broader economy.
At investment and commercial banks, losses tied to bad mortgage investments, which now exceed $450 billion, are certain to rise further if home prices continue to decline and more people default on their mortgages. Last week, Bill Gross, a prominent bond fund manager, offered another forecast for the final bill: $1 trillion. Some market watchers say the figure could be even higher.
Even the collective wisdom of the marketplace has been wrong time and again. The stock market, that weathervane for corporate profits and the economy, keeps swinging from fear to greed and back. A glance at the major stock indexes over the last year reveals a host of false bottoms and fools’ rallies.
The Dow Jones industrials rallied to an all-time high of 14,164 in October, just weeks before the credit crisis worsened and rumors surfaced about problems at Bear Stearns. From there, the index fell 17 percent, to 11,740 in March, then recovered somewhat in the spring, climbing back above 13,000 in May.
This month, the market sank again, tumbling below 11,000 as concerns about the financial health of the nation’s two largest mortgage finance companies, Fannie Mae and Freddie Mac, gripped markets around the world.
But the forecasts keep coming, many of them with what seems like a remarkable level of precision. Last Tuesday, for example, a well-known finance professor at the Stern School of Business at New York University, Edward Altman, declared that Ford Motor and G.M. had a 46 percent chance of defaulting on their debt sometime in the next five years. Not 47 percent or 45 percent: 46 percent.
Mr. Altman’s conclusion, based on a computer model, received big play in some parts of the financial press.
In fact, Mr. Altman found that, on average, companies with an equivalent bond rating to Ford’s and G.M.’s face a 50-50 chance of default within five years. His estimate was based on the performance of hundreds of companies, very few of which matched the brand recognition or reach of the two automakers.
“It was sensationalized somewhat,” Mr. Altman, in an interview, said of his findings. “The chance of default of that type of company is probably a lot lower.”
He said he intended his findings to be used as “a metric” that would offer investors a useful benchmark for comparison. But he allowed that the 46 percent figure “maybe gives it a little more scientific magic than it deserves.” Shares of Ford and G.M. rose that day, though the perceived risk of the companies’ debt increased.
Ideally, predictions on companies and stocks would be “thoughtful, nontheatrical forecasts that take a look at long-term fundamentals,” said Abby Joseph Cohen, a longtime strategist at Goldman Sachs.
But, Ms. Cohen added, less dramatic forecasts rarely make headlines. “If what is being provided to viewers and readers are these theatrical forecasts, that is what many people will pay attention to because that’s what they have available.”
Another source of investment guidance used to come from research analysts, who try to predict quarterly earnings at companies. But there is a great deal of guesswork involved here, too. Analysts correctly predict earnings only a fifth of the time. Nearly two-thirds of quarterly earnings beat estimates, and the rest come in too low, according to data from Thomson Reuters. Many companies, of course, try to defuse overly optimistic forecasts to manage investors’ expectations and deliver “better-than-expected” results.
This year, Wall Street’s crystal balls have performed even worse than in the past. As earnings season for the second quarter winds down, 67 percent of companies reported earnings higher than what analysts had predicted, and 22 percent reported earnings that were worse. Only 10 percent of companies matched analysts’ expectations.
Poor predictions are nothing new in the financial world: in 1999, a pair of prognosticators — James K. Glassman and Kevin A. Hassett — published a book titled “Dow 36,000”; the blue-chip index closed last week at 11,370.
But investors seeking light in a dark period may just have to stick with no one’s predictions but their own.
“We have gone from an abnormally calm period, and we’ve blown right through normal volatility,” Ms. Cohen said. “We are in an exceptionally volatile period.”
Indeed. G.M. shares have bounced back from those bankruptcy fears. If you put a dollar into G.M. on July 2, you would have $1.19 today, a gain of nearly 20 percent. Who would have predicted that?
