Chapter 3
Guess What? A Forecast Is Just a Guess
Forecasting is very uncertain. Especially when it pertains to the future.
—Mark Twain
On October 4, 1957, the Soviet Union successfully launched Sputnik 1, the world's first artificial space satellite. The launch marked something of a turning point in public perception, as sentiment shifted toward a view that perhaps the Soviets had moved ahead of the United States in the race for technical and economic supremacy.
Of course, subsequent events proved otherwise. Sure, the Soviets managed comparable and sometimes even greater success than the United States in several areas, particularly around heavy industries such as steel manufacturing. But these surface victories masked, at least temporarily, the underlying cracks in the central planning system. Food shortages and breadlines, as well as an alarming lack of basic consumer goods, let alone “luxuries” like blue jeans, prompted social unrest, and eventually the complete collapse of the USSR.
But here is the really surprising thing about the collapse of the Soviet Union – no one saw it coming!
Literally every single forecast and analysis of what the world might look like going forward included the survival of the USSR and its continued competition with the United States.
Think about that for a moment. The collapse of communism was arguably the single most important geopolitical event of the second half of the twentieth century, and yet virtually no one saw it coming. Not the legions of PhDs at the world's greatest universities who'd made a career of studying Russian history or international affairs. Not the military hierarchy of the United States or NATO, whose job it was to closely track the enemy's capabilities. Not the State Department. Not the Treasury Department or Federal Reserve with their legions of financial experts. Not even the master spies of the CIA or MI6, whose lives revolved around trying to predict what was going to happen next in the Soviet Union.
That complete failure on the part of tens or perhaps even hundreds of thousands of the world's most intelligent, focused, and motivated people holds a valuable lesson for today's would-be superinvestors. And the lesson is simply this: successfully forecasting the future is difficult, if not impossible, to do on a consistent basis.
But Forecasting Is Fun
Ahh, forecasting. That glorious endeavor whereupon an ordinary person gazes deeply into the void and discerns the shape of things to come.
The prophet!
The seer!
What more wonderful and rewarding occupation could there possibly be?
Sadly, as I'll demonstrate, many economic and financial seers struggle to see past their very noses, and even those with a modicum of skill tend to struggle when it comes to timing and exactitude.
But first, let's be honest. There is something inherently empowering about pitting your wits against the masses and then proving that you, and you alone, are smarter than all the rest. Maybe it's a basic human condition, a little touch of hubris we all carry.
This basic human condition is exacerbated by the American ideal that everyone can be extraordinary. It's not for nothing that Lake Wobegon with its hordes of exceptional individuals has become such a successful archetype of the American psyche. Let's face it, in America anything is possible, which means that at times settling for average can feel a lot like losing.
The financial industry feeds on these twin desires to outsmart and outperform the masses. In fact, Wall Street has built an entire industry upon the basic premise that it is possible to accurately forecast the future. Brokerage firms issue buy and sell recommendations, as well as earnings estimates for individual companies. They also regularly forecast the level of the stock market or interest rates 12 months out. Pundits appear on television to opine on the future course of markets while enthralled viewers anxiously lean forward in their seats so that they might better internalize this sage advice.
Even the Federal Reserve has gotten into the act, publishing periodic updates and forecasts for future economic growth and inflation. Surely, the Fed, above all others, should be able to provide an accurate assessment, because, in addition to their legions of PhD economists, they have an additional advantage: they make the decisions that help shape the course of the economy. In sports terms, this would be like letting the starting pitcher forecast the score of his team's next game.
Given how enticing forecasting can be, as well as its popularity, let's take a look at how accurately various subsets of prognosticators have managed to predict the future.
Economists
The only function of economic forecasting is to make astrology look respectable.
—John Kenneth Galbraith
I love that quote. And it only gets better when you realize that the speaker was a long-time economics professor at Harvard, author of some four dozen books, and advisor to Presidents Roosevelt, Truman, Kennedy, and Johnson. The concept of one of the twentieth century's leading economists disparaging economic forecasting speaks to its difficulty.
Here's an example to validate Galbraith's quote. The Wall Street Journal regularly polls leading economists to ask their prediction on interest rates. The question is a simple one: Will interest rates be higher or lower 12 months from now?
Now while that question is simple, it is of course not easy. Fortunately, there are only two possible outcomes, and so a random coin flip allows for a 50% success rate.
Unfortunately, the world's leading economists aren't quite as accurate as a coin flip, boasting less than a 50% rate of accuracy. This lack of success is troubling, but the story goes deeper still.
In order to successfully time interest rates, you would need to get three things correct:
- The direction (up or down) of rates
- The magnitude of the move (how much higher or lower)
- The timing of the move (or when it will reverse)
If you get all three of these things correct, you can successfully time interest rates.
But here's the kicker: you actually need to get all three of those items correct twice – once on the way out and once again on the way in.
Even if we allow for a 50% success rate on each of these decisions, the odds of correctly moving in and out still look daunting:
Multiplied by
Equals
Now obviously, to build a career around interest rate timing, you'd need to correctly move in and out of the market more than once. Given the preceding numbers, you can see that the odds of doing so are fairly prohibitive.
And remember, those are your odds if you're flipping a coin and getting things right 50% of the time. The world's leading economists, with decades of academic and professional training, are less accurate than those random coin tosses. That means that before you set out on this exercise you'd better have a good basis for thinking that you know more about the direction of the economy and interest rates than the world's foremost experts in the field.
Wall Street Analysts
It makes sense that this is where you have to go if you're looking for some successful forecasts. After all, the folks on Wall Street are smarter than most, work really hard, and have access to all available information. That's why they're paid so well.
Alas, even here we find that crystal balls tend to be muddy at best, and broken at worst. In fact, there have been studies that concluded that the stocks favored by analysts actually do worse than the overall market. For example, a recent academic paper with the exciting title of “Diagnostic Expectations and Stock Returns” reexamined and expanded upon prior research into the subject.
The study looked at analyst predictions made in December of each year, in order to measure how accurate those analysts' forecasts were. The forecasts were for a stock's performance over the ensuing three to five years, and the study covered 25 years of data. If you've been following your brokerage firm's buy and sell recommendation, the results of this research were depressing to say the least.
What the researchers found was that the stocks that the analysts were most optimistic about actually underperformed the stocks that they were most pessimistic about. In other words, the stocks the analysts most wanted clients to buy did worse than the stocks they most wanted clients to sell!
The performance differential between these stocks was startling. If you had ignored the analysts' forecasts and purchased their least favorite stocks, you would have earned a 15% return the following year. If instead you had followed their sage advice, you would have earned 3%. Making matters even worse, the analysts' favorite stocks also had more risk, were more volatile, and performed worse during market downturns!
So to summarize, if you want to take on more risk in your portfolio while also earning returns far worse than the market averages, you now know exactly how to do so. The key is simply to follow the buy and sell recommendations of your favorite Wall Street stock prognosticator.
If instead you'd like to get returns that are five times higher than those of the analysts' recommendations, and with less risk to boot, all you need to do is ignore what the stock forecasters say and instead buy their least favorite stock!
Let me soften this message slightly by saying that there is some value to Wall Street's stock research. That research might give you guidance into the company's financials and how the business is doing. Depending on the analyst's stance, reading such a research report can also help you evaluate an opinion contrary to your own so that you can make sure you aren't missing anything in your own analysis. This exercise can help you avoid a common behavioral trait known as confirmation bias, which we'll discuss in more detail later in the book.
But – and here is the key point – while there may be value to the research, the forecast is less than worthless. Numbers don't lie, and study after study has shown that Wall Street's stock analysts don't know, with any more certainty than you do, exactly what stock is going to do best next year.
Media Pundits
The impact of the financial media is important enough to have an entire chapter devoted to it later in this book, so for now I'll just point out one major problem with listening to media pundits (and here I'm including TV reporters, radio talk show hosts, newsletter writers, and other assorted public figures). The problem is simply this: even if the advice you get is correct, you may not be “tuned in” when the pundits revise their opinions and recommend a change in course.
For example, let's say you're watching a TV show and the host suggests selling XYZ stock at $50. And let's say you do so, and the stock does indeed fall in value, down to say $40. Great! You took what proved to be good advice and it worked out well for you.
But what if the TV host loves it now at $40, buys back in, and the stock goes to $75. Maybe the host never went back on the air to discuss XYZ. Or if he or she did, maybe you weren't tuned in that day. So, the result is that you sold a stock at $50 that is now trading at $75, which is not nearly as great.
The challenge just described is relatively unique to media pundits, who sometimes don't give you both sides of the story. Given that these folks also suffer from the same challenge all forecasters do (it's hard to predict the future), it makes sense to utilize media outlets for what they are intended for, which is information gathering or entertainment, rather than specific forecasts.
The Federal Reserve (the Fed)
The Federal Reserve is staffed by hundreds of PhD economists, all dedicated to tracking and steering the course of the U.S. economy. How well has this massive assembly of brains done at predicting the direction of the economy?
Well, fortunately, the Fed now publishes periodic estimates of future economic growth and inflation. We can then compare these forecasts to actual outcomes to give us a good look at exactly how accurate the Fed's forecasts have been.
As it turns out, the Fed's record has been mixed, at best. What makes this outcome particularly interesting is that the Fed not only forecasts future economic results, but subsequently plays a role in crafting those results, via its monetary policy. So, compared to other prognosticators, the Fed should have an even “easier” time successfully predicting the future, since it plays such a prominent role in shaping that future.
And yet we find that the Fed hasn't been particularly good at predicting things across time.
Now to be fair, there could be an element of gamesmanship to the Fed's forecasts. In other words, Fed forecasts play a role in public perception of both the economy and the future course of monetary policy. As such, the Fed may at times publish forecasts not solely in the interest of accuracy, but also to guide and shape public behavior as an additional tool of monetary and economic policy.
But despite this caveat, it does seem clear that the Fed has been no more proficient at predicting the future than the seers on Wall Street. The challenge the Fed forecasters face is similar to that encountered by all those who attempt to predict the future course of the economy and financial markets.
So, What's the Problem?
The first problem is that the economy isn't a closed science experiment with controllable variables. Ultimately, the economy is a collection of people, and the decisions those people make aren't always logical. For instance, how do you model out the following possibility: someone walks past a shop window and sees something she loves. It's an impulse purchase, but she decides she has to have it. So she goes into the store to buy it, gets up to the cashier, and discovers she accidently left her wallet at home. By the time she goes back home to get it, the urgency of the purchase has faded and she never buys what she saw in the shop window.
Or how about this one: someone has a good, secure job. It's Christmas time and tomorrow he is shopping for presents. That evening, he watches It's a Wonderful Life. He watches George Bailey nearly lose his job and his savings. This prompts irrational fear around all the things that could possibly go wrong with his own finances (remember, people don't have to be logical). The next day, Christmas shopping is scaled way back, just in case something bad happens at work.
Those are just two random possibilities, but the economy as a whole is made up of hundreds of millions if not billions of these sorts of decisions, so you can see how it's difficult to figure out what the end result might be.
Which brings us to the second big issue with forecasting. Chaos theory, or what is more commonly known as the Butterfly Effect, examines how small changes to complex systems can manifest unanticipated results. The term Butterfly Effect refers to a weather phenomenon, with the idea being that a butterfly flapping its wings in one corner of the world can prompt a chain reaction that ultimately leads to a devastating hurricane half a world away.
Of course, a butterfly isn't going to actually cause a hurricane, but the concept is what matters. This Butterfly Effect, or chaos theory, exacerbates all those decisions people make that are so difficult to predict. For instance, maybe because that consumer forgot her wallet and didn't make that purchase, the store went out of business and had to lay off its staff. Those unemployed workers then cut back their spending, which led to less economic growth elsewhere and so on. As you can see, trying to get an accurate handle on what is actually going to happen in the economy is a herculean task. Forecasters probably deserve a pat on the back just for trying!
But, even if they get an A for effort, the fact remains that forecasters, whether from the Fed, Wall Street, or elsewhere, mostly issue conversation pieces, rather than accurate estimates of what is actually going to happen. Use those forecasts as such, and your odds of meeting your financial goals will skyrocket.
The All-Star Team
But what about those shining stars who have gotten the big calls right, those famous folks who've successfully navigated uncertain waters and arrived at the promised land: the out-of-consensus, once-in-a-lifetime market call that turns out to be spot-on. How does the long-term track record of these modern-day prophets actually look?
Because, what could possibly be better than finding a seer who can warn you just ahead of a major market crash? I mean, wouldn't we all have loved to move to cash immediately before Black Monday in 1987 or right before housing collapsed and took the economy and financial markets with it in 2008 or before COVID-19 shut down the economy in 2020?
Believe it or not, there have been a fortunate few who've been skilled or lucky enough to predict such cataclysmic events. So, the question is, does it make sense to seek out this kind of advice?
For this advice to be useful, it must fit three criteria. First of all, it needs to be timely. Warning about an impending crash is useful if the advice is given immediately prior to the crash; moving out of the market months or even years prior to said event is a much less successful course of action. Here, the track record is mixed.
For instance, Meredith Whitney predicted trouble for the financial sector and the demise of Citigroup in October 2007. Her timing was nearly impeccable, and Citigroup declined more than 95% over the next 18 months. Investors in companies such as AIG and Lehman Brothers experienced similar results during that time frame. Elaine Garzarelli demonstrated similar timing when she predicted a stock market collapse the month prior to the 1987 Black Monday crash.
On the flipside, there are plenty of perennially pessimistic individuals (often referred to as “perma-bears”) who have successfully predicted a sharp market decline, but who made their prediction so far in advance that you would have been better off ignoring their advice despite the fact that it eventually turned out to be correct.
Market seers also need to be able to tell you when to get back in. Advice to move toward the sidelines may be useful, but no one gets rich, or meets their financial goals, with a portfolio parked in neutral. So, the second key measurement of success is whether these legends not only warned people when to get out of the market, but also when to get back in. To the best of my knowledge, very few of the people that have gotten famous for predicting market collapses have ever correctly advised the public on when to get back into the market.
Finally, success needs to be repeatable. One-time calls might be the stuff of legend, but it takes repeated successes to build a fortune. So, what is the long-term record of some of the more famous market prognosticators?
This is where the trouble starts. Because the fact of the matter is that very few of the people who have gotten famous for a contrarian market call have been able to sustain that kind of success.
For instance, following her amazing prediction on Citigroup, Meredith Whitney started her own research firm in 2009. That firm closed in 2013. She then started a hedge fund, but that shuttered in 2015. Today, in addition to her 2007 Citigroup forecast, Whitney is best known for a 2010 interview on 60 Minutes in which she forecast a massive wave of bankruptcies in the municipal bond sector. The result of that forecast was the polar opposite of her Citigroup call; municipal bankruptcies have been muted, and the sector as a whole has performed well.
The bottom line is that making an out-of-consensus call is a great way to get famous. Done correctly, you can also capitalize on your 15 minutes of fame and turn it into a lucrative career. But if you're looking for financial guidance that will help you meet your financial goals, you're likely going to need to be right more than once or twice in your lifetime. And sadly, even the most prescient of prophets have yet to demonstrate the ability to do that.
What Should You Do with Forecasts?
Hopefully, the last several pages have convinced you that predicting the future is difficult at best. What, then, should you do with all the information you gather about the state of the global economy and financial markets?
First of all, it's important to differentiate between strategy and tactics. Strategy is represented by your long-term financial plan, which is an outline of your financial goals and a roadmap for achieving those goals. Out of this will come your target asset allocation, or the mix of assets most likely to produce your required rate of return with the lowest possible level of risk.
Once you've established this target allocation, it should seldom change. Large-scale alterations to that allocation should generally come about because of changes to your goals or life circumstances (i.e., marriage, children, retirement, etc.). Market outlooks or forecasts should be incorporated, if at all, only at the margins. This is how institutional investors do it.
For instance, a pension fund might have a target mix of 50% stocks and 50% bonds. If they were optimistic about stocks, perhaps they would reduce their bond allocation to 45%, in order to slightly increase their stock holdings.
Contrast this with the behavior of many individuals, who, during a bull market, might completely abandon their bonds in favor of stocks. This is also true on the downside, with individuals panicking during market declines and fleeing stocks just when they should be buying.
So how can you avoid these mistakes? Well, instead of making wholesale changes to an allocation based upon your market outlook, consider smaller scale, tactical shifts.
Or better yet, utilize a disciplined rebalancing process for your portfolio. This practice forces you to sell what's gone up in value and buy what's declined in value, without relying on any guesses about what the future holds.
Huh. Buying low and selling high.
That sounds like a great game plan for long-term success, and one that will be discussed in far greater detail throughout this book.