Single vs. Multiple Variable Analysis in Market Forecasts

Wednesday, May 04, 2005 | 06:14 AM

How's that for a sophisticated sounding title? What it describes is actually far simpler than it sounds, and if you bear with me, I'll explain this foolishness. Its a favorite Wall Street error, as well as a pet peeve of mine.

What "Single vs. Multiple Variable Analysis" means:  due its inherent complexity, Market behavior cannot be explained or predicted by merely looking at just one thing -- a single variable. If it could, than you would be able to pick that factor -- Earnings, GDP, Interest Rates, Sentiment or what have you -- and perfectly forecast what's gonna happen next. Even a moderately accurate set of directional predictions would have obvious value.

But you cannot. At least not on a regular and consistent basis over a very long time. Given that the computing horsepower on Wall Street rivals NASA, you woulda thought that THE single variable, if it exists, would have been found already. But it hasn't. That's why some of the "cuter" analytical discussions are worthless (or worse!) to investors: Which party controls the White House, the Superbowl victor, and as of lately, Earnings.

The reality is that not only is market behavior a function of multiple variables interacting, they do so imprecisely -- meaning, the exact same (or at least very similar) data sets at different times sometimes produce different results. Its not just one variable, but many dozens.

In a lot of ways, Markets exhibit behaviors quite similar to those predicted by Chaos theory -- dynamic, non-linear, sensitive to initial conditions, etc. (for those who may be interested, James Gleick's Chaos is a marvelous primer on the subject). But quantum physics aside, I think we can all agree that the market is a terrificially complex mechanism for digesting an unholy spectrum of all too many data points. Merely controlling for one single variable over time is a surefire long term money loser.

The reason I bring this up is that the latest refrain from the chattering perma Bulls has been something like this: 

"Earnings are good this quarter, better than expected, and therefore, the market's going higher."

That's not only a gross oversimplification, its simply an untrue statement. This is not a new subject for us, but rather is something we have discussed repeatedly over the past few years.   

And one of our favorite commentators on the subject, Mark Hulbert, addressed this very subject (again) recently:

"Over the past 80 years, faster earnings growth has reliably been accompanied by a more sluggish market - except when earnings were falling out of bed and were more than 25% below year-earlier levels."

Why is that? As we discussed yesterday, these things do not occur in a vaccuum. As earnings heat up, that pressures the Fed to (re)act. By the time they are raising rates, you can assume we are rather late in the cycle:

"Faster earnings growth puts more pressure on the Federal Reserve to raise interest rates. And in a head-to-head contest over which factor has greater impact on the stock market, interest rates usually trump earnings growth.

The 13.6% earnings growth rate that Thomson Financial is now projecting for the first quarter falls in the middle of a category associated with an average S&P 500 gain of 5.8% annualized - about half the market's long-term historical growth rate. Because there is a wide range in the actual returns of the quarters that fall into this category, however, the S&P 500's actual return during 2005's first quarter - minus 2.6% -- is well within the confines of the historical record.

The projected market return for the current quarter would be only slightly higher if Thomson's projection for the second quarter -- 7.2% growth -- is accurate. The category into which this would fall is associated with an average annualized return since 1924 of 9.4%, which is still below the market's long-term average."

Counter-intuitive, to be sure, but the data backs it up. As someone else once said: "If it were all that easy, we would all be filthy rich."



Rates usually trump earnings growth
Mark Hulbert
MarketWatch: 12:01 AM ET May 3, 2005

Wednesday, May 04, 2005 | 06:14 AM | Permalink | Comments (5) | TrackBack (2) add to | digg digg this! | technorati add to technorati | email email this post



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» This Week's Carnival Of The Capitalists from Financial Rounds
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Since WW II the correlation between the change in the market and the change in earnings is -0.002.

In other words it is perfectly random, so even if you have a perfect forecast of earnings growth it is of no help in telling you what the market will do.

Posted by: spencer | May 4, 2005 8:07:57 AM

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