Efficient Frontier
Edited
by William J. Bernstein
The James Grant Paradox
William J. Bernsteinwbern@mail.coos.or.us
James Grant cuts a very impressive figure indeed. He is a noted financial journalist, author, publisher of Grant's Interest Rate Observer, and frequent guest on Wall Street Week. His command of financial history is unparalleled, his deductive powers dazzling, and his gift for phrase is Churchillesque. He doesn't have a bad tailor, either. To give you a small taste of how devastating his prose can be, consider his treatment of the efficient matket hypothesis in the Introduction of his book, Minding Mr. Market:
To suppose that the value of a common stock is determined by a corporation's earnings discounted by the relevant interest rate and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin, and believed Orson Welles when he told them over the radio that the Martians had landed.
Why, then, is Mr. Grant so often wrong? As any viewer of Wall Street Week knows, Mr. Grant has been bearish on stocks and bonds since rocks were hard. In fairness, he has offered some spectacularly profitable advice (for example, shorting the Peso in 1993). However, faithfuly following his recommendations over the past few decades would have been very harmful to your wealth. How could somebody so persuasive, clever, and smart be so wrong?
To answer that question, let's delve into a bit of my wife's family lore. Her late father was a contented, lifelong worker on the assembly line at Mack Truck. He was a large, handsome, generous man, and a pillar of the neighborhood, but nobody mistook him for a scholar. Early 1942 found him in boot camp. Towards the end of basic training he spent a few days taking aptitude tests. The last section consisted of series of nonsense letter sequences, which the examinees were supposed to decode. My father-in-law's eyes glazed over. He began to randomly mark answers. A few days later, he was told by an awestruck sergeant that his cryptanalytic skills were too valuable to be wasted in the infantry. He had obtained the highest score on the code test, and would spend the rest of the war breaking the enemy's ciphers. Alas, my father-in-law was also an honest man. The truth of the matter consigned him to the beaches of Normandy.
The point is this; some problems are so difficult that any effort to solve them is counterproductive. This is the reason why no one can predict the direction of the financial markets with any consistency. The main purpose of market strategists is to make astrologers look good. I never cease to be amazed that most investors think that financial "experts" can forecast stock prices and interest rates from data on unemployment, the Fed Funds rate, and the like. Remember that the best time to buy stocks is usually when economic indicators are the gloomiest. The best time to sell is when there is unlimited blue sky.
So the next time you hear someone predict the direction of stock prices from economic data,
ignore them. Even if they're on Lou Rukeyser every week. Even if their verbal SAT score is 800.
Even if they're wearing a $2000 suit.
William J. Bernstein
wbern@mail.coos.or.us
copyright (c) 1996, William J. Bernstein