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Mat Johnson


March 31, 2009 Groupthink

The Risk of Consensus
Early in my career as an economist, I worked for a large bank that employed a
group of more than twenty forecast economists, most of which held either
PhD’s or ABD’s (all but dissertations) - so relatively smart people, at least on

Once a month, we would all convene to develop the group’s consensus

economic forecast. The first half of the day was devoted to briefings on global
economies, major sector events, government policies, etc. The second part of
the day was spent formulating the short-term GDP forecast. Each forecasting
session started with announcing what the current consensus estimate was.

Being young, but mathematically inclined, my task was simple: listen and
gather the data to input into my long-term forecast model. The official short-
term forecast however, was still derived from the figure that was agreed to at
the end of the day.

The group was incredibly accurate in its GDP forecasts. We rarely missed the
next reported GDP estimate by very much, and as a result frequently “hit the
number.” Oddly however, the model that I maintained seemed to not work at
all. After inputting the senior economists estimates for consumer spending,
business investment, government spending and net exports, my model
produced a forecast that was nowhere near what was actually reported.

After a few months I began to notice that the model was good, but the data
that was fed into it from the meetings was not. In fact, the forecasts prior to
“massaging” the data were very good, often several quarters or a full year in
advance of what was ultimately reported.

I realized then that the group was really forecasting the current consensus,
and the consensus was merely “forecasting” what was known from the data
that had already been released – basic addition and subtraction. So if the
more recent economic numbers were positive, the group became more positive
and vice-versa.

My model on the other hand proved to be long-term accurate, consistently

forecasting that if today was really good, tomorrow wouldn’t be. If the group’s
forecast were very negative, the long-term forecast would turn sharply
optimistic. In essence, the model was consistently reverting to the mean.
What neither the group or the model did very well was explain how we moved
from today to tomorrow, or went from bad economy to good economy.

As my career in the industry continued, I came to realize that it is simply

human nature to focus intently on today, and in particular on what the
consensus is; even if it is widely at odds with rational thinking and longer-term
probabilities. Ultimately, my economic peers were practicing what was known
as “groupthink” – smart people, when together, making really dumb decisions.
Mat Johnson

John Maynard Keynes described this behavior way back in 1936, in his “beauty
contest” analogy to the stock market. Keynes analogy was based on a contest
run in a London newspaper, where entrants were asked to choose the “most
beautiful” contestant from 100 photographs. Anyone who chose the most
popular face was then entered into a raffle.

He concluded that there were several strategies, from the “naïve,” to the
“sophisticated.” The naïve strategy was an individual choosing based on who
they thought was “most beautiful.” A more sophisticated strategy was to
choose based on who the majority might choose, and an even more
sophisticated strategy was to realize that other contestants might choose
based on this latter strategy – in essence trying to “anticipate what the
average opinion expects the average opinion to be.”

In forecasting, contests and investing, groupthink results in the consensus'

view being most important. Take for example, the concept of investment risk.
As individuals, most of us would define risk as the degree of uncertainty,
volatility, or even the risk of permanent investment loss. As a group however,
risk becomes re-defined as deviating from what the consensus thinks.

Specific to investing, this can lead average opinion to value equities not based
on what they think the value is, but rather on what they think everyone else
will predict the consensus price to be. We have seen this in spades in the first
three months of 2009, as market pundits toss out random targets for the Dow
Jones Industrial Average; predicting the market “must fall” to 7,500 then
6,000 then 5,000, before recovering.

As it applies to the recent investing climate, groupthink appears to have

resulted in it now being viewed as more risky to buy shares in real businesses
at depressed prices, than to hold cash, CDs or Treasury bonds that provide
virtually no return, and whose purchasing power is already being destroyed by
inflation. Yet everybody else owns them, and investors know they will get their
money back, thus considering these investments to be “safe.”

What has been lost is the purpose of investing, which is so simple but also
easily forgotten. Investing is laying out today’s savings in order to receive
more money tomorrow. With this in mind, the goal of investing should be to
capture as much investment value as possible today, in order to receive a
greater share of the future increase in wealth. Unfortunately, investing in
stocks is one of the few economic activities where when prices decline quickly,
many buyers actually prefer less of them.

In our view, while we respect the impact of investor psychology, and what it is
capable of doing to stock prices, to be successful we also need to keep a close
eye on the value of equities. On this score, by many metrics, prices have been
pushed to historic lows relative to the value available to shareholders. In fact,
the true value of equities changes slowly and measurably, though stock prices
can obviously change rapidly and dramatically as investor focus shifts from the
distant future to the immediate concerns of today. Fortunately, this runs in the
opposite direction as well.

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Mat Johnson

The Opportunity Emerging From Today’s Market

While many market pundits have been seeking answers as to how today’s
economic crisis might develop by looking back to the Great Depression – an
unfortunate comparison of failures – one might also look back to the same
period to judge the opportunity that might lie ahead.

Measuring the depth of the market decline relative to value, today’s market
has fallen into historic territory, rivaled only by the 10-year periods that
concluded in 1920, 1932 and 1974. Now most will recognize that the
subsequent 10-years to the years above, as including some disastrous years
for the broader economy. However, they did turn out to be fantastic periods
overall for investors.

The average 1-year return following the market bottoms in 1920, 1932 and
1974 was +44%. The average 5-year compound return was +14% per year,
and the average 10-year compound return was +8.5% per year. Notably, the
market crash of 1929, the bulk of the Great Depression and the second OPEC
oil shock all occurred during the 10-year periods above.

Underscoring the potential for a similar long-term period of outperformance of

equities is an astounding level of “cash” holdings relative to the size of the

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Mat Johnson

U.S. equity market – the proverbial “money on the sidelines.” In the past year,
the ratio of money market funds (where last year’s stock sales wound up) to
the value of the U.S. equity market skyrocketed from an already high 20% to
a record 45%. A typical ratio has been something on the order of 10%.

With our estimation of the prospective long-term return on U.S. equities now
being at a lofty 12% a year, versus essentially zero for cash and just 2.8% for
10-year Treasury Bonds, we suspect that this glut of “safe” money will soon
feel the burden of opportunity cost in any sort of market recovery.

Additional information is available upon request.

Although the statements of facts in this report have been obtained from and are based upon sources believed to be reliable, there is no guarantee of their accuracy,
and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute the best judgment(s) as of the date of this
report and are subject to change without notice.
Copyright 2009 by Mat Johnson. Permission to reprint granted without special request.

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