January 31, 2012
Mark Minchin

Be Wary of Economic and Market Forecasts

Kris Vogelsong & Elton Doyle, Private Portfolio Managers

It’s now the end of January and hundreds if not thousands of financial forecasts for 2012 have aired in every corner of the media. Each December through January this annual prediction season sees economists, money managers and market commentators share their annual predictions for economic growth and stock market levels.

The International Monetary Fund (IMF) is the latest to release it’s economic growth forecast but you would be wise not to base any financial decision on the IMF forecasts – it’s Independent Evaluation Office has repeatedly highlighted the inaccuracy of their forecasts after the IMF embarrassingly predicted strong economic growth in Asia in 1997, only to see the region go into its worst economic downturn in 30 years.

More recently and closer to home, the IMF predicted the Australian economy would decline by 1.4%, and unemployment would top 8% in 2009, while in fact Australian GDP grew by 3.3% and unemployment topped at less than 6%.

According to its own figures, the IMF economic growth projections on average differ from the actual growth figures by 36% for developed countries, and while they don’t publish the figure for developing countries like China, India, and Thailand they tell us the error margin is significantly higher.

But we should not single out the IMF. In a relative sense, the IMF’s forecasts are better than most.  A major study by the University of Texas examined 5,000 GDP growth forecasts by leading government and private sector forecasters and found their 1 year GDP growth predictions were off by an average of 45% from the actual figures.

This research is consistent with the dozens of other studies from universities, research bodies, and Government departments that have all examined economic and market forecasting. The research consistently concludes there is no evidence that economic or market predictions are any more accurate than random guesses or simply assuming next years’ results will be the same as this year.

The findings apply equally to individual predictions as well as consensus views. The research also debunks the ‘guru’ status of some forecasters, pointing out that over long periods no individual forecaster has proven to have significantly better accuracy than the averages. However, successfully predicting market turning points has always led to fame, but those fortunate enough to predict these events have almost universally failed in subsequent attempts.

Roger Babson was credited with predicting the stock market crash of 1929 with great fanfare.  Babson went on to lead an interesting life as a philanthropist and presidential candidate for the Prohibition Party but missed the market’s recovery and other fundamental post crash events.

The crash of 1987 brought Elaine Garzarelli to the forefront when Business Week declared her crash prediction the, “call of the century” and $700 million flowed into her fund.  However, in the seven years following the crash, she only outperformed in one and Lehman Brothers eventually fired her in 1994 and wound up the fund.

More recently Nouriel Roubini was credited with and became famous for predicting the GFC, however he followed this up with the erroneous prediction that a deep recession would ensue for 2 to 3 years.  It didn’t, and the Dow Jones is up nearly 50%.

The reality is that with so many predictions sheer probability (rather than skill) results in an occasional correct prediction. The exception could be last year’s Australian share market. In late 2010 The Australian newspaper gathered 20 high profile opinions from the large investment houses, well known market commentators and the Banks, not a single one predicted a decline in share prices for 2011.

The reason no individual or organisation can accurately make economic or market predictions with any reliability is because of the nature of the problem. In simple terms, the complexity of the economy is greater than the models used to make predictions. When combined with the unpredictable influence and psychology of sentiment, accurate and consistent prediction becomes impossible.

Psychologist Phil Tetlock of the University of Pennsylvania conducted an experiment involving hundreds of experts making thousands of predictions over a twenty year period, the insights were revealing.  Firstly, consistent with the substantial body of other research, the predictive capability overall was poor and no better than the informed public.

Secondly, there is a strong correlation between media contact and poor predictions.  Those experts feted out for their opinion by the media ironically had the worst predictive records.

The appetite for these (mostly) worthless predictions is fostered through media as the industry has an ongoing thirst for new content and the sensationalism that some predictions can help create.  Meanwhile, there is no shortage of forecasters willing to offer predictions in an effort to boost their individual or firm’s profile.

The world’s great investors have placed little emphasis on these economic and market predictions, instead focusing on the prospects for individual companies and industries, and we would concur with this philosophy.

Peter Lynch’s summary is most fitting, “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes” while Sir John Templeton put it plainly,  “Focus on value because most investors focus on outlooks and trends.”  Warren Buffet quotes have become almost passé but we’ll end on a favourite, “The only value of stock forecasters is to make fortune-tellers look good.”


Reproduced with permission.

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