By Ethan Haskel (TMF Cormend)
June 7, 2000

If you visited the Solomon Islands in the South Pacific after the end of World War II, you'd have been treated to quite a sight. The natives there had cleared a part of their island to build something resembling a runway for airplanes. They built fires along the sides of these runways, and also a wooden hut where one of the natives could sit. This native attached two pieces of wood to his head, and also made two pieces of bamboo to stick out from the top of his head.

These South Seas natives were waiting for planes to land. During the war, they'd seen lots of planes land on runways just like the ones they'd built. These planes carried cargo highly favored by the islanders. Just before the plane would land, the lights would glow, and a controller with headphones would sit in the control tower, communicating via earphones and an antenna on his head. The planes would always land.

But, alas, no matter how hard the islanders tried, no matter how they dug their runways or placed the bamboo on their heads, no planes would land.

In modern-day Chicago, another type of unusual activity is occurring. A woman is sitting with her computer, looking over lots and lots of economic information and financial reports. She's examining at least 14 economic variables. Things like the federal funds rate, "economic momentum," mutual fund cash levels, and "coincident to lagging indicators." This analyst has developed "mathematical economic models" and "indicators" to predict just how stocks will perform in the next few months. For a $149 annual (nonrefundable) fee, this woman will send monthly reports detailing her analyses. Here's one excerpt from the August 1998 report:

Why the S&P 500 decline?

"Over 95 percent of the time when our indicators were above 30 percent, the stock market has normally experienced 4 percent to 7 percent bull market corrections, or in recent years (because of hedge fund trading) corrections of the quick 10 to 12 percent varieties have been common. In two periods, however, when our indicators were above 30 percent, declines of 20 to 28 percent occurred in the S&P 500. Those periods were December 1961 to June 1962 (a 19.4 percent decline), and September 1976 to March 1978 (a 28 percent decline). The reason for those corrections was a catalyst not associated with recessions or Fed tightenings. The problem in 1962 was Kennedys controversy with the steel industry's pricing tactics, and in 1976 the number of bullish advisors (a contrary indicator) was over 90 percent (the highest in history). The stock market was 10 percent overvalued in 1962, but extremely undervalued before and during the 1976-77 period.

"The correction currently should not last as long as either 1962 or 1977, in our opinion."

"Before the current correction, the S&P 500 was overvalued compared with the 3-month bill rate, but not when compared to the 10-year bond rate. There were, however, many catalysts causing the current correction over the last 1-1/2 months...."

I submit that our South Seas islanders have a lot in common with this analyst, named Elaine Garzarelli.They're both practicing Cargo Cult Science.

Just what is Cargo Cult Science? The term was coined by Nobel Prize-winning physicist Richard Feynman, pioneer in quantum electrodynamics and outspoken cheerleader for science and the scientific process. According to Feynman, the Solomon Islands natives made big mistakes:

"They're doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn't work. No airplanes land. So I call these things Cargo Cult Science, because they follow all the apparent precepts and forms of scientific investigation, but they're missing something essential, because the planes don't land."

Ms. Garzarelli's form is also perfect. Her phrases sound scientific and technical. The numbers seem very precise. The predictions appear definitive. In the summer of 1987, she made her reputation by predicting the subsequent market crash. She has been chosen Businesswoman of the Year by Fortune and probably is making gadzillions of dollars.

Yes, her form is perfect. But her planes don't land. For instance, SmartMoney quotes her as sending out a mailing in November 1996, shouting "SELL NOW! The Next Bear Market is at hand!" The S&P 500 gained 33% in 1997. Oops, never mind.

I don't mean to single out Ms. Garzarelli as a sole practitioner of Cargo Cult Science. The financial world is rife with such Cult Scientists.

It's not hard to find examples. Just click, read, or listen to any nightly recap of the day's market performance. Monday, Edward Yardeni, chief economist at Deutsche Bank Securities was quoted as saying, "The market's doing extremely well. The summer rally clearly is upon us.... We may cover a lot of territory in a short period of time and go sideways for a while.'' Huh?

Or, let's see what Prudential analyst Ralph Acampora is up to. Every market day, he writes a "technical outlook." Here are some of yesterday's comments, fit for publishing in a hypothetical Journal of Cargo Cult Sciences:

"From where we sit, the technical inputs now suggest that the low for the May/June period is in place. Obviously there will likely be concerns about future economic numbers and these concerns could create more daily fluctuations -- but this is all part of the process needed to set the stage for higher prices over time.

"The key to all of these wild swings in price is ROTATION. We continue to monitor our list of attractive names.... We will do our best to highlight those stocks that are coming to the fore. We also must stress that as the new leaders emerge, there will most likely be stocks that suffer as a result. On Friday it became apparent to us that energy, drugs and some consumer issues were being sold as money rotated back into the now depressed tech issues...."

Cargo Cult Science, also called "pseudoscience," is insidious and pervasive in our society. It masquerades in the form of real scientific endeavors, but true scientific principles aren't followed. Cargo Cult Science cheapens the true value of really good science.

Like Wall Street, the social sciences are rife with such "expert scholarship." Studies in the social sciences are often conducted by those with preset agendas, looking for preset answers. Maybe an "experiment" is conducted showing that teaching children by a certain method raises test scores. But there's no control group. Or, if there is a control group, the numbers of students are too small to make a statistically meaningful conclusion. An excellent article in The Atlantic Monthly, The War Against Boys, shows how Cargo Cult Science has been used to twist some of our social policies.

Unfortunately, many of us haven't been trained adequately to tell the difference between Cargo Cult Science and real science. We hear the short sound bites on the evening news, or read a few paragraphs in the newspaper. Because the information is coming from "experts," we believe it to be true.

Over 35 years ago, Richard Feynman, speaking to the National Science Teachers' Association, said:

"I think we live in an unscientific age in which almost all of the buffeting of communications and television, words, books, and so on are unscientific. That doesn't mean they are bad, but they are unscientific. As a result, there is a considerable amount of intellectual tyranny in the name of science....

"The result of this pseudoscientific imitation is to produce experts, which many of you are -- experts. You teachers who are really teaching children at the bottom of the heap, maybe you can doubt the experts once in a while. Learn from science that you must doubt the experts. As a matter of fact, I can also define science another way: Science is the belief in the ignorance of experts."

This doesn't mean all "experts" practice Cargo Cult Science and should be dismissed. But real science should teach us to critically evaluate the ideas of such "experts." We shouldn't just accept them because of a speaker's stature.

Next week, we'll revisit Cargo Cult Science, seeking clues for detection. We'll also try to examine what role if any real science might play in the investment process. If you're interested in reading more, check out Richard Feynman's classic 1974 commencement address to Caltech, or the latest collection of Feynmania, The Pleasure of Finding Things Out.

Beating the S&P year-to-date returns
(as of 06-06-00):

Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %>          +15.1%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %>           +16.7%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %>       -4.3%
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %>   +15.1%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %>         -0.8%
Beating the S&P                  +7.2%
Standard & Poor's 500 Index      -0.8%

Compound Annual Growth Rate from 1-2-87:
Beating the S&P                 +24.0%
S&P 500                         +17.3%

$10,000 invested on 1-2-87 now equals:
Beating the S&P              $179,900
S&P 500                       $84,800