Forecasts and second marriages

Posted by on March 25, 2009 @ 9:20 am in Investing

I’ve been thinking about predictions the past few days since an old pal, Jim, called—his voice brimming with cheer. It was after another of those depressing down days in the stock market that we’ve seen all too often lately. Jim, a longtime options trader, is still involved in investments. I wondered why he was so chipper.

“I just realized,” he chirped, “that the market’s almost back down to where it was in 1995, when you were saying you thought it was getting overvalued.”

I was skeptical about stock valuations back then, and was a bit nervous because the market had risen so far and so many people were so, well, exuberant. Anyway, I checked to see where the market was back in early 1995, and it turns out I was even more off the mark than Jim recalled. In fact, even from its recent lows, the S&P 500 Index would have to drop another 30% or so to get back to the level that had me counseling caution back in 1995.

The stock market, of course, went on rising for five more years after that. And, as I conceded to Jim, there’s a word for a forecast or warning being five years premature: “Wrong!”

Given market forecasting’s poor track record over many decades—even when done by the many individuals who are way smarter than I am—I wonder why investors seem to crave predictions about the markets and the economy. And why people who are otherwise sensible are so willing to make them.

It all brings to mind the famous observation by Samuel Johnson about second marriages being “the triumph of hope over experience.”

I guess the hope of the fabulous profits an investor could make from reliably accurate predictions just overwhelms the many decades of experience that should make us supremely skeptical of anybody’s predictions about the markets. Or the economy.

Last year, two IMF economists wrote a paper that looked at 14 developed and emerging economies and found, among other things, that only 2 of 26 recessions since 1990 had been forecast a year in advance, and that only 8 of 26 downturns were predicted by February of the year in which they occurred.

Shortly after, as if to prove the point, the Federal Reserve Bank of Philadelphia published its twice-yearly survey of forecasts from 34 academic and business economists, as has been done since 1946. The consensus forecast, released June 10, 2008, did find that economists had lowered their estimates of economic growth and increased their forecasts for unemployment. But they fell far short of predicting a recession, even though we were already six months into the current recession. Indeed, the consensus held that “growth for the first half of 2009 is predicted to improve to 2.1 percent.” The 34 economists’ consensus forecast for the S&P 500 Index at June 30, 2009, was 1,496.5—more than double the current figure.

I don’t intend to poke fun at economists or other forecasters. Forecasting downturns or upturns in markets or the economy is so difficult precisely because economic activity and financial markets depend on the emotions and actions of human beings—and we’re creatures who can be unpredictable.

The lesson for investors, I think, is to assume that forecasts—no matter the source—are likely to be wrong. Markets, especially in the short term, can behave in very strange fashion. Our emotions are likely to lead us to focus on recent events—nudging us toward euphoria when the trends have been favorable and toward despair when trends (like those we’re living through) are dismal.

Given the pain endured by investors over the past 15 months or so, it’s not surprising that there are so many gloomy forecasts out there now. Given my own crummy record as a forecaster, the only one I’ll offer is that, when we look back at the bottom of the current market downturn, we’ll be able to find plenty of errant forecasts predicting a further slide.

Notes

• All investing is subject to risks. Past performance is no guarantee of future results.

• Links to IMF.org and PhiladelphiaFed.org will open new browser windows. Vanguard accepts no responsibility for content on third-party websites.

We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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