The S&P 500 had a great 2013.  Up 29.7% – its best performance since 1997.  The Dow Jones Industrial Average (DJIA) ended the year up 26.5% – its best performance since 1995.  And this happened as economic growth lowered the unemployment rate to 6.7% in December – the lowest rate in 5 years.  And overall real estate had double-digit price gains, lowering significantly the number of underwater mortgages.

But if we go back to the beginning of 2013, most Wall Street forecasters were predicting a very different outcome.  Long suffering bear Harry Dent predicted a stock crash in 2013 that would last through 2014, and ongoing cratering in real estate values.  And bear Gina Martin Adams of Wells Fargo Securities predicted a market decline in 2013, a forecast she clung to and fully supported, despite a rising market, when predicting an imminent crash in September. Morgan Stanley’s Adam Parker also predicted a flat market, as did UBS analyst Jonathan Golub.

How could professionals who are paid so much money, have so many resources and the backing of such outstanding large and qualified institutions be so wrong?

An over-reliance on quantitative analysis, combined with using the wrong assumptions.

The conventional approach to Wall Street forecasting is to use computers to amass enormously complex spreadsheets combining reams of numbers.  Computer models are built with thousands of inputs, and tens of millions of data points. Eventually the analysts start to believe that the sheer size of the models gives them validity.  In the analytical equivalent of “mine is bigger than yours” the forecasters rely on their model’s complexity and sheer size to self-validate their output and forecasts.

In the end these analysts come up with specific forecast numbers for interest rates, earnings, momentum indicators and multiples (price/earnings being key.)  Their faith that the economy and market can be reduced to numbers on spreadsheets leads them to similar faith in their forecasts.

But, numbers are often the route to failure.  In the late 1990s a team of Wall Street traders and Nobel economists became convinced their ability to model the economy and markets gave them a distinct investing advantage.  They raised $1billion and formed Long Term Capital (LTC) to invest using their complex models.  Things worked well for 3 years, and faith in their models grew as they kept investing greater amounts.

But then in 1998 downdrafts in Asian and Russian markets led to a domino impact which cost Long Term Capital $4.6B in losses in just 4 months.  LTC lost every dime it ever raised, or made.  But worse, the losses were so staggering that LTC’s failure threatened the viability of America’s financial system.  The banks, and economy, were saved only after the Federal Reserve led a bailout financed by 14 of the leading financial institutions of the time.

Incorrect assumptions played a major part in how Wall Street missed the market prediction for 2013.  All models are based on assumptions.  And, as Peter Drucker famously said, “if you get the assumptions wrong everything you do thereafter will be wrong as well” — regardless how complex and vast the models.

Conventional wisdom held that conservative economic policies underpin market growth, and the more liberal Democratic fiscal policies combined with a liberal federal reserve monetary program would bode poorly for investors and the economy in 2013.  These deeply held assumptions were, of course, reinforced by a slew of conservative commentators that supported the notion that America was on the brink of runaway inflation and economic collapse.  The BIAS (Beliefs, Interpretations, Assumptions and Strategies) of the forecasters found reinforcement almost daily from the rhetoric on CNBC, Bloomberg, Fox News and other programs widely watched by business people from Wall Street to Main Street.

Interestingly, when Obama was re-elected in 2012 a not-so-well-known investment firm in Columbus, OH – far from Wall Street – took an alternative look at the data when forecasting 2013.  Polaris Financial Partners took a deep dive into the history of how markets perform when led by traditional conservative vs. liberal policies and reached the startling conclusion that Obama’s programs, including the Affordable Care Act, would actually spur investment, market growth, jobs and real estate!  They had forecast a double digit increase in all major averages for 2012 and extended that same double digit forecast into 2013 – far more optimistic than anyone on Wall Street.

CEO Bob Deitrick and partner Steven Morgan concluded that the millenium’s first decade had been lost. Despite Republican leadership, the eqity markets were, at best, sideways.  There were fewer people actually working in 2008 than in 2000; a net decrease in jobs.  After a near-collapse in the banking system, due to deregulated computer-model based trading in complex derivatives, real estate and equity prices had collapsed.

“Fourteen years of stock market gains were wiped out in 17 months from October, 2007 to March, 2009” lamented Deitrick.

Polaris Partners concluded the situation was eerily similar to the 1920s at the end of Hoover’s administration.  A situation which was eventually resolved via Keynesian policies of increased fiscal spending while interest rates were low, and federal reserve intervention to both expand the money supply and increase the velocity of money under Republican Fed chief Marriner Eccles and Democratic President Franklin Roosevelt.

While most people conventionally think that tax cuts led to economic growth during the Reagan administration, Polaris Financial turned that assumption upside down and put the biggest positive economic impact on the roll-back of tax cuts a year after being pushed by Reagan and passing Congress.  Their analysis of the 1980 recovery focused on higher defense and infrastructure  spending (fiscal policy,) a massive increase in debt (the largest peacetime debt increase ever) coupled with a more balanced tax code post-TEFRA.

Thus, eschewing complex econometric models, elaborately detailed spreadsheets of earnings and rolling momentum indicators, Polaris Financial focused instead on identifying the assumptions they believeed would most likely drive the economy and markets in 2013.  They focused on the continuation of Chairman Bernanke’s easy monetary policy, and long-term fiscal policies designed to funnel money into investments which would incent job creation and GDP growth leading to an improvement in house values, and consumer spending, while keeping interest rates at historically low levels.  All of which would bode extremely well for thriving equity markets.

The vitriol has been high amongst those who support, and those who oppose, the economic policies of Obama’s administration since 2008. But vitriol does not support, nor replace, good forecasting.  Too often forecasters predict what they want to happen, what they hope will happen, based upon their view of history, their traing and background, and their embedded assumptions.  They believe in the certainty of long-held assumptions, and forecast from that base.

But as Polaris Financial pointed out, in beating every major Wall Street firm over the last 2 years, good forecasting relies on looking carefully at historical outcomes, and understanding the context in which those results happened. Rather than relying on an interpretation of the outcome,they looked instead at the facts and the situation; the actions and the outcomes in its context.  In an economy, everything is relative to the context.  There are no absolute programs that are universally the right thing to do.  Every policy action, and every monetary action, is dependent upon initial conditions as well as the action itself.

Too few forecasters take into account both the context as well as the action.  And far too few do enough analysis of assumptions, preferring instead to rely on reams of numerical analysis which may, or may not, relate to the current situation.  And are often linked to assumptions underlying the model’s construction – assumptions which could be out of date or simply wrong.

The folks at Polaris Financial Partners remain optimistic about the economy and markets for the next two years.  They point out that unemployment has dropped faster under Obama, and from a much higher level, than during the Reagan administration.  They see the Affordable Care Act opening more flexibility for health care, creating a rise in entrepreneurship and innovation (especially biotechnology) that will spur economic growth.  Deitrick and Morgan see tax programs, and rising minimum wage trends, working toward better income balancing, and greater monetary velocity aiding GDP growth.  Their projection is for improving real estate values, jobs growth, and minimal inflation leading to higher indexes – such as 20,000 on the DJIA and 2150 on the S&P.

Bob Deitrick co-authored, with Lew Goldfarb, “Bulls, Bears and the Ballot Box” in 2012 analyzing Presidential economic policies, Federal Reserve policies and stock market performance.