TCS Daily

Rain on the Economic Forecasters' Parade

By Martin Fridson - September 7, 2006 12:00 AM

Investors are keenly interested in the pronouncements of economic forecasters, judging by the massive amounts of ink and airtime allotted to them by the media. It doesn't necessarily follow, however, that heeding the prognosticators is useful in selecting securities. Whether or not seers have insight into future conditions is a testable proposition. If it turns out that they don't, governmental attempts to guide the economy also come into question. Such efforts, after all, rely on forecasts generated by the same methodology that private-sector economists utilize.

Statistics compiled by Bloomberg L.P. shed light on the success of prominent forecasters. Each month, the financial information company surveys 60-plus economists from business and academe. The respondents handicap key indicators for the current quarter (which will not be reported until after quarter-end), and for the next four quarters. Among several indicators covered in the survey, I'll focus on gross domestic product (GDP), the most popular measure of aggregate economic activity.

Records of Bloomberg's GDP survey go back as far as 1993, but there are gaps in the data. My colleague Karen Sterling and I were able to compile an uninterrupted quarterly series from the first quarter of 2001 through the second quarter of 2006. To give the economists the benefit of maximum information availability, we defined the quarterly forecast as the forecast made in the final month of the period.

Exhibit 1: U.S. Real Gross Domestic Product - Year-over-Year Percentage Increase (Quarterly)

Current Quarter Median Forecast and Actual

Sources: Bloomberg, Economagic.

Exhibit 1 compares the economists' median forecast of year-over-year increase in GDP for the current quarter (dashed line) with the actual figure, after all revisions (solid line). By the third month of the quarter, the forecasters already had in hand most of the pertinent data. Nevertheless, they missed the actual GDP gain by an average of 1.06 percentage points. In individual quarters, the economists collectively overshot by as much as 1.5 percentage points and undershot by as much as 3.0 percentage points.

The forecasters cannot even claim the saving grace of being unbiased in their errors. They overestimated current-quarter GDP 15 times and underestimated it just 6 times, with one bulls-eye. This record lends aid and comfort to critics who accuse investment firms' forecasters of being predisposed to bullishness.

To be sure, "prediction" is something of a misnomer for the task of estimating the current quarter's GDP. Even if economists were highly accurate in this endeavor, it would provide scant value to investors, who seek to stay ahead of events. Much more helpful would be a precise read on the economy's vigor one year out. Unfortunately, the forecasters haven't collectively distinguished themselves in that department, either.

Exhibit 2: U.S. Real Gross Domestic Product - Year-over-Year Percentage Increase (Quarterly)

Year-Ahead Median Forecast and Actual

Sources: Bloomberg, Economagic.

Exhibit 2 shows that during 2001-2006, the year-ahead forecast hardly varied from one year to the next. The median prediction was in the range of 3.1% to 4.0% in every single quarter. Perhaps not coincidentally, the actual quarterly GDP increase over the past 25 years (1981-2005) averaged 3.14%. The forecasters, in aggregate, perennially thought that one year hence, business conditions would be just about average. In reality however, actual GDP gains gyrated between 0.2% and 7.5%. The forecasters' nearly inert consensus was all but worthless.

Certainly, in any given quarter some forecasters diverged from the consensus and came close to the actual number. That didn't help decision-makers, however, if in each instance it was a different and random subset of economists who got it right. Individual forecasters naturally encourage the belief that they belong to a highly select group that consistently outperforms the conventional wisdom. Using the Bloomberg data, investors can put such representations to a rigorous test.

If any economists can document a statistically valid record of precision, they are doing better than the Federal Reserve Board, which is commonly thought to enjoy a certain informational advantage. Each February, the FRB's "Monetary Report to the Congress" includes a forecast of the year-over-year increase in GDP for the upcoming fourth quarter. An analysis in Gene Epstein's recent book Econospinning indicates that during 1994-2005, the Governors annually allowed themselves leeway of 0.5 to 1.5 percentage points. That tolerance improved the Board's chances of being right, yet the actual GDP gain landed within the predicted range only once in 12 years -- and then, just barely. The 1995 figure came in at the very bottom of the FRB 2.0%-3.25% range.

The imprecision of economic forecasts isn't a comment on the forecasters' intelligence or work ethic. Rather, it demonstrates that the economy is too complex a system to be adequately captured by existing modeling techniques. The rational response to this realization is a combination of caution and humility.

One implication for investors is that it's highly speculative to bet that the market is misjudging the earnings outlook for cyclical companies. The prevailing prices of economically sensitive stocks reflect a consensus estimate of future GDP. Forecasting GDP more accurately than the consensus is a tall order, even with the help of the bird's-eye view and analytical resources enjoyed by the Federal Reserve Board.

As for government policymakers, the message is to forget about trying to control short-run economic performance. Given the lagged impact of fiscal or monetary intervention, deciding whether stimulus or restraint is needed depends on knowing where GDP will be a few quarters down the line. That isn't something economists have shown they can reliably predict. A more appropriate mission for government policy is to refrain from meddling that ultimately undermines confidence among business and consumers

Martin Fridson is the author of Unwarranted Intrusions: The Case against Government Intervention in the Marketplace (John Wiley & Sons, Inc.) and publisher of Leverage World, a research service focusing on the high yield bond market.


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