Reading Between the Lines of Morgan Stanley’s Mea Culpa

Some of the most widely read financial news stories involve projections by Wall Street strategists such as Morgan Stanley’s Michael Wilson, who recently conceded he’d misjudged the direction of US stocks this year. There are investors who dismiss these reports, claiming they are like horoscopes, written in sufficiently vague terms that can always be spun after the fact as being correct. Other investors weigh the dueling reports from different brokerage firms to try to refine their investment strategy. Is either view correct? What is the right way to interpret these reports?

The first point is to separate the reports from the headlines. A strategist has three jobs: (1) find some useful information to communicate to investors, (2) get attention and (3) support the firm’s business. Most strategists I know consider (1) the real job, the one they care about, but without (2) nobody listens and without (3) you don’t keep your job.

Strategists for major global financial institutions have large teams and budgets, and access to a vast amount of information and expertise from firm activities and discussions with big investors, business executives and officials. They are smart and hard-working. They’re selling what economists call a “post-experience” good — something consumers can only evaluate after purchase. That is, investors must decide whether to trust a call today and only learn later whether the call was sound. Sellers of post-experience goods focus obsessively on reputation — strategists must be right often enough to attract any following.

Even the strongest believers in efficient markets acknowledge that there is value to all this information and analysis. Stocks do have some momentum and valuation matters. Direction is hard to predict, but guessing future volatility is easier. Even simple quantitative rules can identify times when real risk-adjusted returns of stocks are higher or lower than the historical average.

Why does this not translate into active mutual fund managers beating the market? Because even when stocks are less attractive than usual, they’re still the best option for most investors. In poor equity markets, few investments do well. Avoiding equities when they seem overvalued and levering them up when they seem undervalued can easily cost more in fees, taxes and loss of diversification than it gains in successful market timing. Sophisticated hedge funds with low costs and high leverage — and Warren Buffett with his genius — can play these games for profit, but most investors are better off sticking with low-cost, well-diversified index funds through thick and thin.

Therefore, while there’s lots of useful information and opinion in good strategist reports, most of the time they will not lead to dramatic portfolio changes.