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hi the latest Memo from the Legendary Super investor Howard Marks Mr Marks is co-founder and co-chairman of oak tree Capital Management the largest investor in distressed Securities worldwide he's also a best-selling author of investing in stock market related books some of which we have summarized on this channel his memos are extremely popular in the investing Community with none other than Warren Buffett stating that he always looks forward to these memos the September 2022 memo is titled the illusion of knowledge in this video let's take a look at the top two takeaways from this memo this can find this video as well and make sure to subscribe to receive next videos on these memos let's continue there are two kinds of forecasters those who don't know and those who don't know they don't know in this memo Mr Marks talks about the futility of macro forecasting and predictions particularly for Superior investment performance his main point is that macro predictions are so complex that he does not think one it can be done with any reasonable accuracy and two even if somehow we can manage to predict a certain macro Trend the impact it has on the micro that is a company's performance is unlikely to be reasonably predicted as well overall his view is that this can be a good intellectual exercise for some but it does not bring about any meaningful change in investing performance he Dives deeper into why he thinks so and uses some really insightful codes to summarize his argument let's take a look at the top takeaways take away one macro forecasting is complex and unreliable according to Mr Marks one needs to have a reliable process to convert inputs such as a huge number of variables covering the macro environment such as inflation employment interest rates productivity supply chain issues foreign policy implications Etc into a reliable output and it is this process that he says is so complex that is likely not trustworthy he says in order to produce something useful be it in manufacturing Academia or even the Arts you must have a reliable process capable of converting the required inputs into the desired output the problem in short is that I don't think there can be a process capable of consistently turning the large number of variables associated with economies and financial markets the inputs into a useful macro forecast the output forecasters have no choice but to base their judgments on models be they complex or informal mathematical or intuitive models by definition consist of assumptions if a happens then B will happen in other words relationship and responses but for us to willingly employ a model's output we have to believe the model is reliable so when Mr Marx thinks about modeling an economy his first reaction is to think about how incredibly complicated it is he gives an example for instance the U.S has a population of around 330 million all but the very youngest and perhaps the very oldest are participants in the economy thus there are hundreds of millions of Consumers Plus millions of workers producers and intermediaries to predict the path of the economy you have to forecast the behavior of these people if not for every participant then at least for group Aggregates which seems an impossible task a real simulation of a U.S economy would have to deal with billions of interactions of nodes including interactions with suppliers customers and other Market participants around the globe is it possible to do this is it possible for example to predict how consumers will behave if they receive an additional dollar of income if Energy prices rise squeezing other household budget categories if the price for one good rise is relative to others will there be a substitution effect all models are based on certain types of assumptions but then there are unknowns how can a model of an economy be comprehensive enough to deal with things that haven't been seen before or haven't been seen in modern times one's assumption won't be able to include things that are unexpected and unplanned this is yet another example of why a model simply can't replicate something as complex as an economy another example he gives of this is the covid-19 pandemic it caused much of the world's economy to be shut down turned consumer behavior on its head what aspect of pre-existing model would have enabled it to anticipate the pandemic's impact yes we had a pandemic in 1918 but the circumstances were so different no iPhones Zoom calls Etc to render economic events during that time of little to no relevance to 2020.
he says what we are talking about here is the future and there's simply no way to deal with the future that doesn't require making of assumptions small erroring assumptions regarding the economic environment and small changes in participants Behavior can make differences that are highly problematic for him the bottom line is that output from a model May point to the right direction much of the time when the assumptions aren't violated but it can't always be accurate especially at critical moments such as inflection points and that's when accurate predictions would be most valuable take away two macro forecasting is unlikely to provide Superior value it ain't what you don't know that gets you into trouble it's what you know for sure that just ain't so Mr Mark asks are you a consumer of forecasts are there forecasters and economists on the staff where you work or do you subscribe to their Publications and invite them in for briefings as was the case with my previous employers if so do you know how often each has been right have you found a way to rigorously determine which ones to rely on and which ones to ignore is there a way to quantify their contributions to your investment returns I ask because I've never seen or heard of any research along these lines the world seems incredibly short on information regarding the value added by macro forecasts especially given the large number of people involved in this Pursuit despite the lack of evidence regarding its value macro forecasting goes on many of the forecasters are part of teams managing Equity Funds or they provide advice and forecast to those teams what we know for sure is that actively managed Equity Funds have been losing market share to index funds and other passive vehicles for decades due to poor performance of active management and as a result actively managed funds now account for less than half of the capital in U.S Equity mutual funds could the unhelpful nature of macro forecast be part of the reason the only place I know to look for quantification regarding this issue is the performance of so-called macro hedge funds while the table above shows is that according to hedge fund research the average hedge fund willfully underperform the S P 500 in the period understudy and the average macro fund did considerably worse especially in the period between 2012 to 2017.
given that investors continue to interest roughly four and a half trillion dollars of capital to hedge funds they must deliver some benefit other than returns but it's not always what that could be this seems to be especially true for the macro funds he also points out that I certainly don't know everyone in the investment world but among the people I do know or am aware of there are only a few highly successful macro investors by the number of instances of something is Tiny it's an indication as my mother used to say that they are the exceptions that prove the rule the rule in this case is that macro forecasts rarely lead to exceptional performance for me the exception less of the success stories proves the general truth of that assertion even if you somehow manage to get an economic forecast correct that's only half the battle you still need to anticipate how the economic activity will translate into a market outcome this requires an entirely different forecast also involving innumerable variables many of which pertain to psychology and thus are practically unknowable the bottom line for Mr Marx is that forecasts can't be right often enough to be worthwhile he has described it many times but he's going to restate his view of macro forecasts most forecasts consist of extrapolation of past performance because macro developments usually don't diverge from prior Trends extrapolation is usually successful it has more forecasts are correct but since extrapolation is usually anticipated by the security prices those who follow expectations based on extrapolation don't enjoy unusual profits when it holds once in a while the behavior of the economy does deviate materially from past patterns since this deviation comes as a surprise to most investors its occurrence moves markets meaning an accurate prediction of the deviation would be highly profitable however since the economy doesn't diverge from past performance very often correct forecast of deviation are rarely made and most forecasts of deviation turns out to be incorrect because we have a extrapolation forecasts most of which are correct but unprofitable and B potentially profitable forecast of deviation which are rarely correct and thus are generally unprofitable hence most forecasts don't add to returns for now that's it from us hope you enjoyed and learned from this video smash that like button and subscribe to receive the follow-up videos on Howard Mark's memos thanks
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