Is economic forecasting worthwhile?

Is economic forecasting worthwhile?

Image by Daniel Albany from Pixabay

“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”  Evan Esar

One of the features of the current economic environment, in which central banks have to consider the twin dangers of inflation and recession and somehow navigate a path between them all, is that they are obliged to attempt to forecast what future conditions will be.  As the Bank of England’s recent raising of interest rates following an unexpectedly high inflation figure demonstrates, this is no easy task.

For an investor of course, it is always worth reminding ourselves that public markets derive their valuations from looking forwards, in that the expectations of each investor determine whether they prefer to buy or sell and the aggregate of all those decisions results in the current prices of tradeable securities and commodities.

The unfortunate thing with recessions is that they are only identifiable in arrears when the relevant data has been collected and assimilated.  Consequently, it is not uncommon for a recovery to be underway by the time the recession is declared, even allowing for the fact that economic data is prone to revision once it has been published.  Such was the case with the most recent coronavirus-related recession, which saw UK GDP decline by 18.8% in the second quarter (April to June) of 2020 although there were sharp increases in both June and July of that year.

So if economic forecasts are unhelpful when trying to predict investment returns, how about forecasts of the stockmarket by those who earn a living from forecasting?  Fortunately a recent study[1] by three academics in the United States considered this very question.  The authors looked at three sets of market return forecasts for the US economy, one of which had around 60 respondents, another around 400 and the third which consolidated several individual data sources.

What they discovered was interesting, even if not particularly surprising to those of us who have seen similar studies before.

    1. None of them managed to outperform a simple random forecast which predicted future returns by using the average of previous returns;
    2. A typical investor who used the forecasts to switch between the components of a simple portfolio comprising a risk-free asset and the broad US stock market would have been worse off (by up to 18% a year) compared to one who assumed that market returns would follow a random walk path;
    3. Most damning of all, while both professional forecasters and individual investors underperformed the historical average, the professionals produced even worse results than the individual investors.


So what lessons can we learn from the study?

Those able to earn a living from economic or indeed market forecasting are undoubtedly intelligent and highly qualified in their chosen fields, as they have managed to persuade employers to employ them in the expectation of delivering a positive economic benefit to their businesses.  However, it is apparent that actually delivering this benefit is extremely difficult given the ability of events to deliver surprises (which are, by definition, hard to predict reliably) and the difficulty of also predicting how other investors will react.  Some of those other investors will be similarly qualified, while others may be relying on gut feelings or wild guesswork but they each get a vote when they trade and the market cannot tell (and does not care) which one applies to each transaction.

While the general underperformance of the market as a whole might be expected therefore, it should perhaps be of more concern to their employers that in this study, the professionals underperformed the average private investor household, whose members should presumably be expected to spend less time studying the subject.  Maybe despite the averages, those employers simply feel, as do investors who hire portfolio managers who claim to be able to predict the future better than the average, that they have some special ability to hire people who are better than the average.

Unfortunately for them, the historical record is littered with examples of individuals from many fields who were widely considered to be geniuses but who subsequently turned out to be just as fallible as the rest of us and in some cases (looking at you, Bernie Madoff), even outright crooks.  So why do businesses choose to invest in hiring such people?  That’s a question better left to them to answer but given the importance of having an apparently rational explanation for the decisions they make, maybe the analogy of the blind knife thrower is appropriate.  He may not win many prizes for accuracy but he sure entertains the audience.

For those of us not blessed with the ability to persuade others of our exceptional ability to forecast the future and to reward us for doing so, fortunately we can rely on the market to do a pretty good job of doing it for us.

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results and forecasts are not a reliable indicator of future performance.