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economic forecasting

"...the amount of knowledge we have in a certain area will not help us predict what will happen if the events are inherently unpredictable." --Thomas Kida

Economic forecasting predicts the rise and fall of stock prices, or such things as the gross national product and the inflation rate. Forecasters employ a variety of methods and formulas. Some forecasters, some of the time, make apparently successful predictions on the basis of their methods. They appear to have identified real patterns in the market. The reality, however, is that all forms of successful economic forecasting are illusory because the economy is a complex system significantly affected by irrational forces (Kida 2006). In short, there is no logical system that can predict the market because the market isn't logical. Anyone who thinks he has discovered a system that can "beat" the market is deceiving himself. (Note: "beating the market" means doing better than an index of funds, such as Standard and Poor's 500, over some period of time.)

One fact hinders acceptance of the claim that markets are unpredictable: some people have correctly predicted that the market would rise or fall and some have made a killing from time to time by following their unique and special method of prediction. Yes, and a broken clock is right twice a day and some people do win the lottery using special methods of selecting their numbers. Even though some people have made correct predictions about the market, those predictions should not be taken as evidence of the power of any particular method of economic forecasting. Psychics make correct predictions from time to time. Does that mean they're really psychic?

Two popular systems for predicting the rise and fall of stock prices are technical analysis (TA) and fundamental analysis (FA). Technical analysts are also called chartists. They are fond of collecting stock price charts like the one below.

 

 

 

 

 

 

 

A typical price chart for a stock will show the price of the stock over time. A chartist looks for patterns in charts, patterns he believes are predictive. Is there any scientific evidence that there are some truly predictive patterns in stock price charts? No, but there is scientific evidence that chartists see patterns in random processes (Malkiel 2007). According to Thomas Kida, there is a wealth of scientific research going back nearly half a century demonstrating that "charting is useless." "Technical analysis can't beat the market" (Kida 2003: p. 122). The long and the short of it is: past prices of stocks are extremely poor predictors of future prices. Why are there so many technical analysts working for brokerage firms, then? Because they recommend a lot of trades and trades generate commissions (Malkiel 2007).

Does the fact that the scientific evidence shows that technical analysis is no better than chance in predicting the price of stocks mean that nobody ever makes any money buying and selling stocks following the advice of a technical analyst? Of course not. By chance alone many brokers are going to make recommendations that make money for their clients. The illusion is in thinking that technical analysis provides a magic formula that will continue to bring success forever and ever. No, in the long run, there will be some big winners and some big losers, but the average among most of the investors will be no better than what you would get if you let a monkey throw darts at a list of all the stocks listed on the New York Stock Exchange.

Is fundamental analysis any better than technical analysis? Fundamental analysis "attempts to determine the intrinsic (true) value of a stock based on a firm's underlying economic variables." The technique assumes that when the market price is below the intrinsic value, the stock is undervalued and the price will rise when the market properly adjusts" (Kida: p.146; Sherden 1999). Despite its popularity, the scientific evidence shows that fundamental analysis is no better than technical analysis at predicting the price of stocks (Kida 2003; Malkiel 2007).

Think about it. If stock analysts could really beat the market consistently, wouldn't they be stinking rich? Do you really think they are a clan of benevolent elves whose only goal is to help people like you get rich from their technical advice? Their cousins appear in infomercials all the time, telling stories about unfathomable riches that await you if you invest in their program. That's how they make their money, folks. Not by using their program, but by selling it to others!

What about the superstars? Aren't there freelancers and top mutual fund managers who consistently beat the market because of their special expertise? Aren't there investment managers from pension funds, insurance companies, and foundations that consistently beat the market because of their genius? No. It's easy to pick a person or a fund and show its superiority to the market, as long as you are very selective about what time period you evaluate. Over the long haul, however, no one person and no fund does better than chance at beating the market (Sherden 1999; Kida 2003). It is true that some fund managers do better than others over certain periods of time. The few examples of consistently superior performance over a period of, say, four or five years, however, are what one would expect by chance (Malkiel 2007). "Analyses of the Forbes honor role funds over the period 1973 to 1998 indicate that they underperformed the S&P 500 stock index (Kida 2003: p. 142; Malkiel 2007). In short, there's no scientific evidence that professionally managed funds, as a group, perform any better than a randomly selected group of stocks (Kida 2003: p. 143; Malkiel 2007).

What about the geniuses at the Fed, the Council of Economic Advisers, the Congressional Budget Office, the Bureau of Economic Analysis, and the National Bureau of Economic Research? Surely these top economic advisers with their large budgets and sophisticated tools of analysis are able to consistently make accurate predictions about such things as the gross national product and inflation. Wrong! "A review of twelve studies on forecasting accuracy, covering the periods 1970 to 1995, concluded that economists can't even predict the major turning points in our economy. The top economic institutions listed above were wrong in their predictions of forty-six out of forty-eight turning points in our economy (Kida 148). That's about a 4 percent success rate. Not too impressive.

Nineteenth century historian Thomas Carlyle called economics the "dismal science." Much attention has been paid to what Carlyle meant by 'dismal.' It seems apparent that the problem with economic prediction is not with its dismalness, but with the fact that

...economics typically does not use the scientific method, where hypotheses are tested by observing what goes on in the economy. Instead, economists often develop elaborate theories that may be logically consistent, but are often based upon unrealistic concepts. For example, a basic assumption of economics is that people are consistently rational in their behaviors. (Kida 2003: p. 149)
 

The scientific evidence, however, strongly suggests that our behavior is often irrational and therefore unpredictable. Even so, I predict that economists will continue to make economic predictions, providing society with mostly useless information at great cost. I also predict that economists will have as many satisfied customers as the psychics who claim to be able to see into the future. I predict that it will be not only economists and stockbrokers who will reject the idea that the market is essentially unpredictable. I predict that many customers, even those who have lost bundles of money in the stock market following the advice of their brokers, will refuse to believe that the market is unpredictable. They know from personal experience that it works. Personal experience is not a very good guide, however, when the one evaluating it is not an unbiased observer. The defenders of the predictability of the market will point to their successes and rationalize their failures as flukes or some such thing.

I predict that stockbrokers and financial advisers will not go out of business in the near future. There will always be plenty of customers for them who will not accept William Sherden's dismal view:

The stock market is a psychological soup of fear, greed, hope, superstition, and a host of other emotions and motives.

A few will look at the evidence and conclude that, so far, the only consistent economic fact is that the market rises over time despite recessions and other problems. Thus, the only "sure-fire" investment strategy for those who want to invest in the stock market is to invest in an index fund and keep it there for a long time.

Another strategy, of course, would be to buy one of those books by a stock analyst or a professional gambler that reveals a "secret" method of beating the odds.

Who knows?

You might get lucky.

See also affect bias, anchoring effect, availability error, representativeness error, and the hidden persuaders.

further reading

Ariely, Dan. (2008). Predictably Irrational: The Hidden Forces That Shape Our Decisions. HarperCollins.

Drucker, Peter F. 2006. The Practice of Management. HarperBusiness.

Gardner, Daniel. 2008. The Science of Fear: Why We Fear the Things We Shouldn't--and Put Ourselves in Greater Danger. Dutton.

Gilovich, Thomas. 1993. How We Know What Isn't So: The Fallibility of Human Reason in Everyday Life. Free Press.

Gilovich, Thomas. Dale Griffin and Daniel Kahneman. 2002. eds. Heuristics and Biases: The Psychology of Intuitive Judgment. Cambridge University Press.

Kahneman, Daniel. Paul Slovic, and Amos Tversky. eds. 1982. Judgment Under Uncertainty: Heuristics and Biases Cambridge University Press.

Kida, Thomas. 2006. Don't Believe Everything You Think: The 6 Basic Mistakes We Make in Thinking. Prometheus.

Levine, Robert. 2003. The Power of Persuasion - How We're Bought and Sold. John Wiley & Sons.

Malkiel, Burton. 2007. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. Revised and updated. W. W. Norton & Co.

Sherden, William A. 1999. The Fortune Sellers: The Big Business of Buying and Selling Predictions. Wiley.

Sutherland, Stuart. 1992. rev. 2nd ed. Irrationality. Pinter and Martin.

Taleb, Nassim Nicholas. 2008. Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. Random House.

Taleb, Nassim Nicholas. 2010. 2nd ed. The Black Swan: The Impact of the Highly Improbable. Random House.

articles

Paranormal Wall Street by Karen Stollznow "...there’s nothing rational or logical about unqualified strangers advising 'clients' on life-altering decisions, based on gut-feelings, emotions, hunches, hopes, and intuition. Ironically, these are the very impulses that have contributed to the current economic crisis."

news stories

 29 July 2009. Newsweek declares the recession is over, but the U.S. Commerce Department says that orders for durable goods fell 2.5 percent last month, much larger than the 0.6 percent decline that economists had expected. It was the biggest setback since a 7.8 percent fall in January. "Much of the weakness reflected a 38.5 percent decline in orders for commercial aircraft, an industry that has been hurt by the global recession, which has crimped air travel and triggered some airlines to cancel existing orders for planes."*

There is good news in the housing industry, however. New U.S. housing starts and permits have stopped declining and are on the increase.* And home prices in major U.S. cities registered their first monthly gain in nearly three years.*

The Matrix, but with money: the world of high-speed trading ("Only about three percent of the trading volume on the NYSE is actually carried out by means of traditional "open outcry" trading, where flesh-and-blood humans gather to buy and sell securities. The other 97 percent of NYSE trades are executed via electronic communication networks (ECNs), which, over the past ten years, have rapidly replaced trading floors as the main global venue for buying and selling every asset, derivative, and contract.")

Last updated 26-Nov-2011

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