Above the Market. The Problem with Predictions. By Alan Guerry. A Wakeup Call

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1 Above the Market By Alan Guerry Financial Advisor Morgan Stanley The Problem with Predictions " the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." Ben Bernanke, Federal Reserve Chairman, 3/28/2007 I couldn t count on all my fingers, and possibly throwing in a foot s worth of toes, the number of times in the last few months someone has asked me what I believe the stock market is going to do. I don t state this in any negative way; upon hearing my occupation, with the markets trading at sky-high levels with nary a whiff of downside for who can remember how long, it is a natural question to ask. Especially so if you have some skin in the game. In reply, I used to parrot the smart sounding things that my firm s research analysts would publish. Things like, well, based on current fundamentals and the somewhat stable geopolitical outlook, we think there is plenty of room to run from here, maybe 12 to 14% more upside by year end. Of course that was early in my career back in the 90s. A Wakeup Call As the economic grim reaper of 2007 was becoming an unpleasant memory in the rear view mirror, something important occurred to me. I was employed by one of the largest, most well respected financial institutions in the world; we had some of the brightest, best educated and most highly compensated research analysts at our fingertips. And you know what? I didn t recall a single memo, white paper or research report warning about the impending economic catastrophe that was about to hit.

2 That is certainly no knock on my firm or any research analyst; when it comes to the stock market no one can accurately predict the future, especially those that wear decorative ropes around the only part of the body that let s air get to the brain (i.e., ties). Of course in retrospect one can usually find a seer who accurately forecast whatever nasty event has come to pass. Unfortunately these Nostradamus impersonators typically make a living out of predicting calamities, most of which never actually happen. I wouldn t stake too much capital on someone who has predicted 8 of the last 2 market collapses. Dominoes and the Stock Market That s not to say all forecasts are impossible. Consider a line of dominoes; it s not tough to predict exactly where or when one will topple once the first is knocked over. Dominoes are an example of a linear system x happens, followed by y, then z. Like Prince said, always, every time. Unfortunately, the stock market is a non-linear system and the same inputs and conditions do not always generate the same results. Like Sands through an Hourglass If you have read any of my articles over the last several years you know that I exhibit a good bit of intellectual promiscuity. I am not ashamed to grab ideas from disciplines outside my little bubble of finance, like music, psychology, biology and history. In this case, I am borrowing from physics. In 1999, a scientist by the name of Per Bak conducted some experiments with an hourglass that made non-linear systems a bit easier to understand i, or at least easier to understand why we don t completely understand them. Most everyone has seen an hourglass in action. Sand drops from top to bottom, forming a little volcano-shaped cone until tiny avalanches PublicDomainPictures.net cause sand to fall down the sides of the mini-mountain. The longer the cone builds, the bigger the eventual avalanche.

3 Bak studied this process in an attempt to predict the actions of the sand pile; what he found was that the actions of the sand were completely unpredictable, with avalanches sometimes occurring after hundreds of grains were added, and other times after thousands. In short, he found that the avalanches were not a function of the size of the pile or the number of grains of sand, but instead were based on the interactions between the individual grains of sand. Understanding and quantifying those interactions were, and still are, way beyond our ability. Know Your Limits So if we can t predict the action of something simple like sand in an hourglass with only one interactive agent, is it really conceivable that anyone could predict the action of the stock market where there are literally millions of different agents, both human and computer, employing various data sources and operating with different experiences, motivations and behavioral biases? Hopefully you would agree the answer is a resounding, absolute no. However, there are a few things we can learn from Bak s sand pile experiments and apply to our understanding of the stock market and investing. The Takeaways Avalanches are infrequent; you shouldn t assume that the next grain will cause the sand to fall, regardless of how big the pile has grown. Avalanches though infrequent, do occur. The little pile of sand always falls to create a base on which to climb even higher. No one can predict the next avalanche. Wall Street experts are a staple on television giving you their two cents, but you and I both know that television is for entertainment and those guys are simply the performers. We can be sure that an avalanche will happen and be prepared. Make sure you have a plan in place and that your investments are allocated in a way that will survive if not thrive when the inevitable happens.

4 So, What s the Market Going to Do? What do I say now when people ask me what I think the market is going to do? Something along the lines of: The stock market tends to rise more than it falls so I think it s going to go up. Is that what is actually going to happen? No one really knows, so as a rule we try to make sure that our clients are prepared for whatever the markets throw at us, both good and bad. At first, I didn t think people would want to hear the truth, that there is no way to accurately guess what the stock market is going to do. I also didn t believe that people would eat Tide Pods. As it turns out, I was wrong on both counts. Alan Guerry is a Vice President and Senior Portfolio Manager with the Global Wealth Division of Morgan Stanley in Alpharetta. His focus with the Guerry/Kinney Group includes risk control, asset allocation and portfolio diversification strategies ii. He is also a volunteer in the children's ministry at North Point Community Church and with the Make-A-Wish Foundation of Georgia. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates. (C) 2018 Morgan Stanley Smith Barney LLC. Member SIPC. CRC / Lakeview Parkway, Suite 300 Alpharetta, GA (770) NMLS #

5 Alan Guerry Trey Kinney The Guerry/Kinney Group at Morgan Stanley Visit us on the web i ii Diversification does not ensure against loss.