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By Noah Solomon
Special to Financial Independence Hub
According to satirist Karl Ludwig Borne, “Losing an illusion makes one wiser than finding a truth.”
I have become completely disavowed of the illusion that:
1.) People are able to predict the future with any degree of accuracy or consistency.
2.) Investors can improve their results by forecasting (or by following the forecasts of others).
Not even the almighty Federal Reserve, with its vast resources, near limitless access to data, and armies of economists and researchers has been particularly successful in its forecasting endeavors. For example:
- Near the height of the dotcom bubble in 1999, Fed Chairman Greenspan argued that the internet was bringing a new paradigm of permanently higher productivity, thereby justifying lofty stock price valuations and encouraging investors to push prices up even further to unsustainable levels.
- In 2006, Chairman Bernanke brushed off the most pronounced housing bubble in U.S. history, stating that “U.S. house prices merely reflect a strong U.S. economy.”
- In late 2021, the Fed determined that the spike in inflation was “transitory.” It neglected to combat it, leaving itself in a position where it had no choice but to subsequently ratchet up rates at the fastest pace in 40 years and risk throwing the U.S. (and perhaps global) economy into recession.
The following commentary describes the underlying challenges relating to economic and market predictions. I will also provide some of the reasons why, despite strong evidence to the contrary, investors continue to incorporate them into their processes.
The Three Enemies of Forecasting: Complexity, Non-Stationarity and People
There is a near infinite number of factors that influence economies and markets. The sheer magnitude of these variables makes it near, if not completely impossible, to convert them into a useful forecast. Further complicating the matter is the fact that economies and markets are non-stationary. Not only do the things that influence markets change over time, but so do their relative importance. To produce accurate forecasts economists and strategists not only need to hit an incredibly small target, but also one that is constantly moving!
For most of the postwar era, economists and central banks relied heavily on the Phillips curve to inform their forecasts and policies. An unemployment rate of approximately 5.5% indicated that the U.S. economy was at “full employment.” Until the global financial crisis, any declines below this level had spurred inflation. Confoundingly, when unemployment fell below 5.5% in early 2015 and hit a low of 3.5% in late 2019, an increase in inflation failed to materialize.
This problem is well summarized by former GE executive Ian H. Wilson, who stated “No amount of sophistication is going to change the fact that all your knowledge is about the past and all your decisions are about the future.”
Saved by 50/50
When it comes to economies and markets, it’s hard enough to be right on any single prediction. A forecaster who gets it right 70% of the time would be a rare (and perhaps even a freakish) specimen.
However, investment theses are rarely predicated on a single prediction. When a forecaster predicts that inflation will (a) remain stubbornly high, (b) rates will rise further, and (c) that these two developments will cause stocks to fall, they are technically making three separate predictions. Even with a 70% chance of being right on each of these forecasts, their overall prediction about the market has only a 70% chance of a 70% chance of a 70% chance of being right, which is only 34.3%! Continue Reading…
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