Thoughts From The Frontline: Economicus Terra Incognita – Growth Forecasts by John Mauldin
“The most reliable way to forecast the future is to try to understand the present.”
– John Naisbitt
“We really can’t forecast all that well, and yet we pretend that we can, but we really can’t.”
– Alan Greenspan
Welcome to 2016. Tradition dictates that you spend the first few weeks or so reading forecasts for the coming year. I can say with certainty that most of them will be wrong. A smaller number may hit the target. Unfortunately, no one knows which forecasts will fall into which category.
For the last 16 years my first letter of the year has also been a forecast issue, and I will continue to go with that tradition – but with one major caveat. I do not base my forecasts on mathematical models or some finely honed methodology, but on my sense of where the economic world stands today and where I think it might likely be in the near future.
Actually, I’m going to spend the first few pages demonstrating that the mathematical models used to forecast GDP and all sorts of interesting economic events are basically nonsense.
For me, forecasting the year ahead is somewhat like being an explorer who comes to the top of a high new mountain pass along with a group of his friends and looks far out in the distance and sees another mountain pass, shrouded in clouds but offering the promise that it’s possible to continue the journey. It is clear to him that they should all forge ahead to find a way to that next mountain pass, but between his location and his destination lie all manner of unknown geographical features, not to mention the prospect of unfriendly natives who may want to contest their passage.
So today, as we crest the mountain pass of a new year, I will look off in the distance and tell you what I see. Let me be clear, though, that I’m not coming back from the future and telling you what it’s like; I am merely hoping to get our general direction right. Some years the path ahead seems remarkably straightforward and clear of obstructions. I can tell you right now that this year the challenges seem particularly fog-shrouded. But what’s an explorer to do but to press ahead?
Before we begin, I want to suggest you mark out time in 2016 to attend my Strategic Investment Conference. This year we’ve moved the event to Dallas. The dates are May 24-27.
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I’m proud to say that SIC probably has more repeat attendees than any conference I know. This fact speaks to the care with which my conference team organizes the event and the quality of our speakers. A side effect is that the bar is raised a little each year. Somehow I have to deliver a better-than-ever program year after year – and somehow we’ve always done it.
My goal in designing the agenda is to give you a mixture of old favorites as well as new perspectives. Our confirmed speakers so far (in no particular order) are George Friedman, Mark Yusko, Pippa Malmgren, Charles Gave, Lacy Hunt, Anatole Kaletsky, David Rosenberg, David Zervos, Gary Shilling, Louis Gave, and Neil Howe. We will be confirming several others within the next few weeks. You probably know at least some of those names. If not, you should. Just this initial group is quite a brain trust.
This year I’ve juggled the schedule to give us more time for informal networking opportunities. SIC attracts an impressive group of attendees, and every year I hear from people who made invaluable business contacts at the conference. We are going to be using an app for the conference that, among other cool options, will help you network and find people whose ideas and information will enhance your own life. Note that this extra “networking” feature is completely optional. (We are still accepting sponsors, too, if your company would like to reach several hundred high-powered investors and money managers from around the world.)
For more information, you can visit the SIC 2016 website. Register by Jan. 31 and you’ll save $500 off the walk-up rate.
Two notes before we start. At the beginning of the letter I am going to launch a few nukes on the banality of making predictions based on models. That is at least the first half of the letter. If you want only my musings on events to look for in the coming year, skip down about halfway.
Second, and VERY IMPORTANT. At least to me. This is the typically the most forwarded letter of the year. If you are reading me for the first time, this letter is free – you can subscribe at www.mauldineconomics.com by simply entering your email address. And you can get free emails from a brilliant group of writers and analysts who are far smarter than I am, if you choose. The whole team at Mauldin Economics looks forward to serving you. Now, let’s jump in!
“What will the stock market do this year?” It seems like a simple question. You might wish for a simple answer to it, and think that people who watch stocks for a living should know that answer. Not so. The evidence shows they are no more accurate than anyone else is.
Morgan Housel of The Motley Fool skewered Wall Street’s annual forecasting record in a story last February. He measured the Street’s strategists against what he calls the Blind Forecaster. This mythical person simply assumes the S&P 500 will rise 9% every year, in line with its long-term average.
The chart below show’s Wall Street’s consensus S&P 500 forecast versus the actual performance of the S&P 500 for the years 2000–2014.
The first thing I noticed is that the experts’ collective wisdom (the blue bars) forecasted 15 consecutive positive years. The forecasts differ only in the magnitude of each year’s expected gain.
As we all know (some of us painfully so), such consistent gains didn’t happen. The new century began with three consecutive losing years, then five winning years, and then the 2008 catastrophic loss.
The remarkable thing here is that forecasters seemed to pay zero attention to recent experience. Upon finishing a bad year, they forecasted a recovery. Upon finishing a good year, they forecasted more of the same. The only common element is that they always thought the market would go up next year.
Housel calculates that the strategists’ forecasts were off by an average 14.7 percentage points per year. His Blind Forecaster, who simply assumed 9% gains every year, was off by an average 14.1 percentage points per year. Thus the Blind Forecaster beat the experts even if you exclude 2008 as an unforeseeable “black swan” year.
This data raises plenty of questions, starting with, “Why do investors listen to forecasters who are so consistently wrong?” I have a guess, but let’s first look at Morgan Housel’s answer. (I should note that Morgan is my favorite writer at The Fool.)
The first question is easy. I think there’s a burning desire to think of finance as a science like physics or engineering.
We want to think it can be measured cleanly, with precision, in ways that make sense. If you think finance is like physics, you assume there are smart people out there who can read the data, crunch the numbers, and tell us exactly where the S&P 500 will be on Dec. 31, just as a physicist can tell us exactly how bright the moon will be on the last day of the year.
But finance isn’t like physics. Or, to borrow an analogy from investor Dean Williams, it’s not like classical physics, which analyzes the world in clean, predictable, measurable ways. It’s more like quantum physics, which tells us that – at the particle level – the world works in messy, disorderly ways, and you can’t measure anything precisely because the act of measuring something will affect the thing you’re trying to measure (Heisenberg’s uncertainty principle). The belief that finance is something precise and measurable is why we listen to strategists. And I don’t think that will ever go away.
Finance is much closer to something like sociology. It’s barely a science, and driven by irrational, uninformed, emotional, vengeful, gullible, and hormonal human brains.
For the most part, I agree with Morgan. Investors want to believe that certainty is possible, that crunching the right numbers or listening to the right guru will reveal what lies ahead. The idea that markets are inherently messy and disorderly frightens them. It’s much more comforting to think that someone out there has a crystal ball that you just haven’t found yet.
I’ll add a twist to Morgan’s answer. I think what many investors really want is a scapegoat. The only thing worse than being wrong is being wrong with no one to blame but yourself. Forecasters keep their jobs despite their manifest cluelessness because they are willing to be the fall guy. Present company excepted, of course.
There used to be a saying among portfolio managers: “No one ever gets fired for owning IBM.” It was the bluest blue chip, one that everyone agreed would always bounce back from any weakness. If IBM made you have a bad year, the boss would understand.
Wall Street strategists serve a similar purpose. If, say, Goldman Sachs forecasts a good year, and it turns out not so good, you will be well-armed for the inevitable discussion with your spouse, investment committee, or board of directors: “I was just following the experts.”
Compare that to the alternative. How does that discussion turn out if you build your own forecasting model and it delivers dismal results? The story probably ends with you sleeping in the doghouse and/or polishing your resumé.
In the short run, hiring a scapegoat, er, forecaster, seems the path of least resistance. That’s why so many people choose it. But in the long run, that path leads you nowhere that you want to go. You will be in fine company as you underperform, but underperform you will.
People also look to forecasts that reward their confirmation bias, reinforcing and validating their understandings of markets and investment strategy. Sadly, I must confess that I much prefer to hear a forecast or read analysis that confirms my own biases. Which is one reason I make sure to read the analyses of those who don’t agree with me.
I typically ignore – for good reason, as we will see below – forecasts based on mathematical models. I much prefer the assessments of those who analyze the future in terms of trends and general economic forces, giving us their own sense of direction about the interplay of the complex drivers of the economy. But that’s just me.
All right, so if forecasting the stock market is harder than it looks, how about forecasting the economy? Surely the Federal Reserve has a good handle on future growth prospects.
If that’s what you think, prepare to be disappointed.
We can’t say the Fed doesn’t try. In 2007 the Federal Open Market Committee (FOMC) started releasing GDP growth projections four times a year. They do this in the same report where we see the much-discussed interest-rate “dot plots.” It is called the “Summary of Economic Projections,” or SEP.
A 2015 study by Kevin J. Lansing and Benjamin Pyle of the San Francisco Federal Reserve Bank found the FOMC was persistently too optimistic about future US economic growth. They concluded:
Over the past seven years, many growth forecasts, including the SEP’s central tendency midpoint, have been too optimistic. In particular, the SEP midpoint forecast
(1) did not anticipate the Great Recession that started in December 2007,
(2) underestimated the severity of the downturn once it began, and
(3) consistently overpredicted the speed of the recovery that started in June 2009.
So, it isn’t just Wall Street that wears rose-colored glasses – they are fashionable at the Fed, too. Lansing and Pyle provide helpful charts to illustrate the FOMC’s overconfidence. This first one covers the years 2008–2010.
The colored lines show you how the forecast for each year evolved from the time the FOMC members initially made it. Note how they stubbornly held to their 2008 positive growth forecast even as the financial crisis unfolded, then didn’t revise their 2009 forecasts down until 2009 was underway – and then revised them too low. However, they did make a pretty good initial guess for 2010, and they stuck with it.
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