Counterpoint for Peter Bernstein Theory

Financial analysts are professional forecasters. But why study the economy, a traditional lagging indicator, if you want to forecast investment measures? The investment record of this process is only rarely better than random and when you take account of the expenses of achieving these results, they come out a little bit less than chance. Why do it at all with that unconvincing record of success?

Economic forecasts are supposed to be meaningful. But if you believe that asset prices reflect a forecast of future outcomes, it would seem quite difficult to use a technique that reaches back into the past to get an idea of the future. But that is what economic forecasting does. It is teased for forecasting three recessions for every one hat actually happens. No wonder it is called the dismal science.

Financial Times economics columnist Sir Samuel Brittan makes a pointed reflection on the practice of forecasting: ''The golden rule for economic forecasters is: forecast what has already happened and stay at the cautious end. Forecasts tell us more about the present and the recent past than about the future."

Poor methods, bad models and inaccurate data are all blamed for the recurrence of serious forecast errors. But according to Oxford economics professor David Hendry, these are not the primary cause of systematic mistakes. Rather, unanticipated large changes within the forecast period are the culprit. The primary fault of economic forecasting is in not rapidly adjusting the forecasts once they go wrong.

Hendry uses an analogy from rocket science: a rocket to the moon is forecast to reach there at a precise time and location, and usually does so. But if it is hit by a meteor and knocked off course or destroyed the forecast is systematically badly wrong. That outcome need not suggest poor engineering or bad forecasting models and certainly does not suggest that Newtonian gravitation theory is incorrect.

Peter Bernstein and Economic Forecasting

Despite the pressures for early and often forecasts, a number of Wall Street and City economists do as good a job as any forecasters, among them Abby Joseph Cohen, Stephen Roach and Edward Hyman. Most such investment economists are good students of market conditions careful keepers of useful data, and on occasion creative in extracting some kind of signal out of the noise. Ed Yardeni, for example, the chief economist at Deutsche Bank Securities, turns his website into a cyber-chart room. If you want to access data and view charts, Yardeni's site is an essential stop. He also makes his commentary available in a section for clients that is password protected, but a substantial amount of the content is openly accessible.

One economic commentator stands amid the few that many of us would class as the best: Peter Bernstein. He grew up heading his father's investment firm, Bernstein MacCauley, in New York. He was the first editor of the Journal of Portfolio Management, founded by Gilbert Kaplan, and has received many awards, among them the
highest honor granted by the investment management industry's professional body, the Association of Investment Management & Research.

Bernstein is able to walk on both streets with practitioners and academics. He writes a newsletter, Economics and Portfolio Strategy, to test and disseminate his analyses. And writing is one of his main strengths: his two books on the history of risk and on how capital ideas came to Wall Street have been regulars on the business best-seller lists during the 1990s.

Like a good academic, Bernstein marshals all the arguments, especially those that are counter to his own position. His mid-February 1998 letter, for example, examined the case for exuberant stock prices in the United States, giving particular emphasis to the market's reliance upon an all-knowing Federal Reserve for economic management. Bernstein concluded that "stocks are a risky investment and should be managed accordingly." Since that analysis was approximately the same as his November 1997 conclusion, he was ahead of the wave and for the right reasons. Bernstein is also faster than most to admit where he has been wrong and to try to examine what led him astray or, as he jokes, "what led the market astray when it failed to act the way I thought it would."

Understanding Economic Forecasting

Almost every financial services firm has an extensive economic forecasting effort. It is usually part of a so-called top-down investment process, which starts with an outlook for the economy and monetary conditions, continues to the strongest industries, follows with detailed company study for stock selection and may include an overlay of technical analysis to provide a timing dimension. Some would add analysis of social and political conditions even before economic studies (see Politics and Investing).

Economic forecasts derive from models usually of the aggregate national or global economy, but sometimes of parts of those economies: particular industrial sectors, regions of the world or even single products or firms. Basic approaches to forecasting simply extrapolate the past; more sophisticated models attempt to understand the sources of past changes and build them into their forecasts. The latter requires knowledge of economic history and economic principles, though, even then, forecasting is by no means an exact science. But while the accuracy of economists' predictions is frequently a target of jokes, forecasting remains a popular pursuit.

Forecasts for the macroeconomy are published regularly by academic institutions, thinktanks, governments, central banks and international organizations like the OECD and the IMF. In these places, modeling can, to a certain extent, be conducted free of the constraint of producing quick and usable data on a daily basis. But in the investment world, forecasts are required to be done early and often. A relatively short-term outlook is normally the limit of their aspirations what will happen to interest rates within the next month? with decision-makers demanding rapid output that they hope will be directly relevant to their immediate problems.

Much of the output of financial market models is naturally closely guarded in the hope that it may bring advantage to its owners and their clients. But, at the same time, investment economists like to maintain a public profile for marketing purposes, and are often called on by the media to give their opinion on the latest macroeconomic developments. Their interpretations of economic data may give some clues as to how the financial markets will react, though more often than not, they are explaining why the markets have already reacted as they did. Invariably too, there are disagreements about what various indicators mean, depending on different beliefs about the economy, and whether the firm is taking an optimistic or pessimistic view of the markets.

Each month, the Economist polls a group of financial forecasters and calculates the average of their predictions for real GDP growth, consumer price inflation and current account balances in a variety of countries. More specialized services like Consensus Economics survey over three hundred economists each month and offer details on average private sector predictions.

Bruce Wasserstein and Corporate Restructuring

In the mid-1980s, there was an avalanche of takeovers of underperforming companies, the targets of institutions and arbitrageurs who suspected that, with the help of plentiful leverage, they could increase corporate values by mobilizing assets. Often that term meant disposal of non-performing assets. In this earlier age of corporate restructuring, Bruce Wasserstein was an enfant terrible. M&A deals were being done at premiums of 3040% above market prices and Wasserstein would be in the middle designing strategies to make them happen.

This was also the heyday of shark repellents and poison pills. Often, the other side would be lawyers and PR people trying to set defenses against shareholders who had corporate control in mind, artfully removing shareholder rights whenever they might be exercised to change corporate control. But the SEC formed an advisory committee to evaluate many of these activities and concluded that the market mechanisms must be left unimpeded.

Wasserstein's youthful energy tapped intensity suited to the pulsing business of deals. Always very well prepared, he worked with arbitrageurs, lawyers, accountants and regulators to move business combinations forwards over institutions dedicated to thwart combinations, which, in the light of hindsight, seemed to favor one group of investors over another. He went on to found his own successful investment banking firm, his personality skills leading him on the correct path.

In his 1998 book Big Deal, Wasserstein surveys "the battle for control of America's leading corporations," including his own role in the past two decades or so. He describes five waves of mergers beginning in the mid-1800s: the first involved the building of the railroad empires; the second, in the 1920s, saw merger mania fueled by a frothy stock market and rapid industrial growth; the third happened during the go-go years of the 1960s and featured the rise of the conglomerate; the fourth occurred with the hostile takeovers of the 1980s, driven by names such as Icahn, Boesky and Milken; and finally, a fifth wave happening today. Wasserstein attributes the explosion of M&A activity at this turn of the century to the need for companies to reposition themselves in today's ever changing competitive environment:

Corporate Restructuring

One of the most high profile features of the business and investment worlds is corporate restructuring the mergers and acquisitions (M&A), leveraged buyouts, divestitures, spin-offs and the like that are contested in the ''market for corporate control." These recombinant techniques of corporate finance often have an impact on the financial markets far beyond the individual companies and sectors they involve and, in theory, all return real control of companies to shareholders. Virtually without exception, stock prices of participating companies rise in response to announcements of corporate restructuring. But are such events good for investors beyond the very short term?

The late 1990s have seen yet another wave of M&A activity. Indeed, the number and value of mega-mergers in 1998 set new records, a 50% increase on activity in 1997, itself a record year. This has reawakened the populist cry that such mergers do not create new wealth, that they merely represent the trading of existing assets rearranging the deck chairs on the Titanic. What is more, it is argued, the threat of takeover means that managements take too short-term a view, bolstering stock prices where possible, investing inadequately for the future and, where a company has been taken over in a leveraged buyout, perhaps burdening it with excessive debt.

On the other side of the debate, the primary argument in favor of M&A is that they are good for industrial efficiency: without the threat of their companies being taken over and, in all likelihood, the loss of their jobs, managers would act more in their own interests than those of the owners. In particular, this might imply an inefficient use of company resources, overinvestment, lower productivity and a general lack of concern about delivering shareholder value. Feeble supervision of corporations often leads to mismanagement, it is argued, and while increased shareholder activism is one option Certainly, a takeover bid is frequently beneficial to the shareholders of the target company in terms of immediate rises in the stock price (though acquisitions often have a negative effect on the profitability and stock price of the acquirer). And managements that resist takeover may be doing it for their own interests rather than those of their investors. Senior executives may use such bizarre devices as shark repellents and poison pills, which make it extremely costly for shareholders to replace the incumbent board of directors.

The next steps for investor relations are straightforward:

First, companies, funds and countries that wish to inform their constituency should maintain and publish FAQs (frequently asked questions), a common practice in industry. All questions with whatever favorable or unfavorable answer can be made available on a bulletin board. It is the next step to the ultimate in transparency, the ultimate being when the answers are created automatically regardless of the questions asked.

Second, companies should actively trade their own shares with open disclosure of transactions on an instantaneous basis. Companies would reveal their own interplay between business conditions, availability of capital and their assessment of prospects by their actions.

Third, and in the same vein, insiders would be encouraged to trade with no reservations on when, except that they would have to be identified as an insider.

Technology makes all these possible, and investor relations would be advanced, providing the user with live, real and significant information individually customized for each. It is possible today. But no one has done it.

Corporate governance: What Next?

Corporate governance is all about the relationship between investors and the companies in which they invest. But what does investor relations really mean? To the practitioner, it means a craft of communication striving to be a profession. To a shareholder receiving its output, it is a necessary way to understand markets and companies. To corporate officials, it is a convenience to fend off the time-consuming quest for information that is often a distraction from running a business. All these views are correct but they are far from the story of investor relations today.

An unprecedented eighteen-year bull market has multiplied all financial service tasks. Abby Joseph Cohen of Goldman Sachs notes that compensation for financial service workers has been the only area of wage inflation in the present business cycle. And many others note that financial assets are the only inflating assets in a deflationary economy. It is reasonable to look at the macro-influence of a bull market creating the need for ever more competent and ever more highly paid investor relations people. But that is not the whole story either.

At its base, investor relations is about communication of fact. Usually, it is what is today called "push" through releases, attractive venues and targeted sources. Investor meetings and lunches have given way to conference calls and internet group emails in turn to global videoconferences. Facts are still distilled by lawyers but, curiously, with the most important facts withheld during blackout periods when the most significant developments are taking place.

With computer databases and search capabilities, remarkable things can be done to turn masses of data into information. Most of the innovations have already taken place in the corporate world, especially in comparative retail sales. Now, they are finding their way into finance: for example, screening of the type used at www.fortuneinvestor.com can survey sixteen thousand securities on six hundred variables; and charts of historical activity on almost anything are available at www.bigcharts.com and www.yardeni.com. Hundreds of tools like these are converting the "push" from investor relations into a "pull" by users in control of what they want, what they do with it and the conclusions to be reached.

Investor persuasion is moving to the user through the empowerment of technology. The nub of judgment remains in an elusive corner of agency finance, behavioral sciences and computation. But each single user has access to machinery to do the chores, which is low-cost, readily available, global and instantaneous. Like Microsoft endorsing the internet, which may ultimately be its downfall, so the alert investor-relations person will provide these tools to make the user's job easier and better.