Some Thoughts on Economic and Market Forecasting

My friend and fellow San Diegan Robert Seawright had a thoughtful piece on forecasting yesterday.  He discussed the folly of forecasting and why it can be silly to rely on people’s predictions of the future at times.   While I agree with much of what bob says I also think there’s a rather rational reason for some level of forecasting.  The problem is, we often take it to an unreasonable extreme.  Let me explain.

When I approach the world of finance and economics I am really just trying to understand my surroundings so I can build a better understanding of this world.  By having a better understanding of my surroundings I am confident that I can engage in that world more efficiently.  I know I can’t engage in this system perfectly or without error.   But through understanding it I can make more informed decisions that will help me navigate it better.  A lot of my work on the monetary system is all about building a more informed understanding of the world around me so I can engage in that system more efficiently.  For instance:

• When I stated back in 2010 that QE would not cause hyperinflation, I was working from an operational understanding of how QE works.  This meant that it would be irrational to load up on gold, silver or sell T-bonds short based on this misconception.
• If you understood the profits equation over the years you understood that the trillion dollar plus budget deficit was likely to be supportive of corporate profits and the stock market.
• If you understood that Greece was operationally, different from the USA then you understood there were very different risks between owning Greek government bonds and US government bonds.

These are just a few of the numerous ways that a sound operational understanding of the monetary system could have helped you make better decisions regarding the financial system in recent years.   These understandings aren’t just about being right.  In a lot of cases, it’s about understanding the financial world so you can avoid the folly of falling for the biases that steer so many people to incorrectly position their portfolios at times.  And much of the time, portfolio construction isn’t about being right so much as it’s about avoiding big mistakes.  This is about increasing the odds of being right by knowing what’s wrong.

But I want to also highlight something that I believe is far more nefarious than the idea that we can make pinpoint predictions about the future.  And that’s the idea that we can’t predict the future at all therefore we shouldn’t even try.  I find this to be rather naive.  After all, even the most passive and supposed “forecast free” portfolio is indeed making a forecast.  It just so happens that in the case of many passive index fund “forecast free” approaches they’re making a long-term bullish forecast without actually acknowledging it.  This just so happens to be a pretty good bet (most of the time) over the long-term (and an efficient one with regards to taxes and fees), but that doesn’t mean it’s not a forecast of the future.  And it doesn’t mean it’s always a smart bet.  But when the stock market has been going up for many years in a row we tend to see the same people trot out this old line about “see, forecasting anything is stupid!”.  The only thing more naive than assuming you can predict the S&P 500’s closing date on December 31st, 2014 is assuming that a passive buy and hold approach is “forecast free”.

And that’s the kicker here – we’re all making forecasts.  The difference is that some of us are approaching the world of forecasting knowing that we will make mistakes, but understanding that we can better prepare ourselves for the future by understanding some big picture understandings.  I don’t think you need to be actively involved in the markets on a daily basis or actively forecasting every move in order to succeed.  But I do think you need to be informed.  And you certainly need to be building SOME forecast with SOME plan.  Otherwise, you’re just naively floating in the wind.