Tuesday, October 4, 2011

The Accuracy of Experts' Forecasts

By Larry Swedroe

There’s an overwhelming body of evidence on the inability of forecasters to make accurate predictions. This inability is one reason why efforts to outperform the market without taking more risk have failed with such persistence. This is true for both the stock and bond markets. The following is a recent example that while it might be easy to make a living selling forecasts, it’s very difficult for even the experts to make accurate forecasts.

A year ago, the Reuters news agency polled 16 money market dealers who do business directly with the Federal Reserve. These “primary dealers” — banks or broker-dealers — are market makers for government securities. They even consult directly with the US central bank and Treasury about funding the budget deficit and implementing monetary policy.

One might hypothesize that if anyone could get the forecast right it would be them. Reuters asked the dealers for their forecasts for Treasury bond yields three, six and 12 months ahead. Their consensus forecast was for 10-year Treasury note yields to rise from 2.5 percent to 3.2 percent by September 2011. Investors paying attention would shorten maturity risk. Today, we know that they were not only off by about 1.5 percent (the 10-year note now yields about 1.75 percent), but more importantly from a strategy standpoint, they got the direction wrong. Investors who paid attention not only failed to earn the term premium that existed at the time, and missed out on the large capital gains that the fall in rates produced, but now they’re faced with reinvesting at much lower interest rates.

But they weren’t the only ones that got it dead wrong. In February 2011, the bond “king” Bill Gross announced that the world’s biggest bond fund had reduced its US government-related debt holdings from 22 percent in December 2010 to just 12 percent in January 2011, the lowest in two years. In March, PIMCO announced it had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Fed ended its quantitative easing program.

By August, Gross admitted he had made a big mistake, and he reversed course.

The aforementioned failures of the so-called experts to get forecasts right is nothing new. William Sherden, author of The Fortune Sellers, was inspired by the following incident to write his book. In 1985, when preparing testimony as an expert witness, he analyzed the track records of inflation projections by different forecasting methods. He then compared those forecasts to what is called the “naive” forecast — simply projecting today’s inflation rate into the future. He was surprised to learn that the simple naive forecast proved to be the most accurate, beating the forecasts of the most prestigious economic forecasting firms equipped with PhDs from leading universities and thousand-equation computer models.

Sherden reviewed the leading research on forecasting accuracy from 1979 to 1995 and covering forecasts made from 1970 to 1995. He concluded that:

  • Economists cannot predict the turning points in the economy. He found that of the 48 predictions made by economists, 46 missed the turning points.
  • Economists’ forecasting skill is about as good as guessing. Even the economists who directly or indirectly run the economy (such as the Fed, the Council of Economic Advisors and the Congressional Budget Office) had forecasting records that were worse than pure chance.
  • There are no economic forecasters who consistently lead the pack in forecasting accuracy.
  • There are no economic ideologies that produce superior forecasts.
  • Increased sophistication provided no improvement in forecasting accuracy.
  • Consensus forecasts don’t improve accuracy.
  • Forecasts may be affected by psychological bias. Some economists are perpetually optimistic and others perpetually pessimistic.

Economist and Nobel Laureate Paul Samuelson observed: “I don’t believe we’re converging on ever-improving forecasting accuracy. It’s almost as if there is a Heisenberg [uncertainty] Principle.” Michael Evans, founder of Chase Econometrics (now IHS Global Insights), confessed: “The problem with macro [economic] forecasting is that no one can do it.”

The bad news is that no matter how much we want to believe in fortune tellers, the problem is that they all have cloudy crystal balls. One reason for the inability of even the experts to see through those clouds is that markets have a nasty tendency to provide surprises, which by definition are not forecastable. The result is that the efforts to try and manage returns are highly likely to prove unproductive. Instead, you should focus on the things you actually can control, the types and amount of risk you take, diversifying those risks prudently, costs and tax efficiency.

And finally, remember that since the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than do the economists.

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