Ben Whitmore and Dermot Murphy, fund manager and assistant fund manager to the Jupiter Income Trust.
“The only function of economic forecasting is to make astrology look respectable” said Ezra Solomon, and as a leading economist in his day then he should know1. When it comes to investment, we certainly subscribe to the view that economic or business forecasts are unhelpful at best and dangerous at worst.
A book written by the then-Chief Economist at the National Association of Realtors was published in 2005 with an extraordinary title: Are You Missing the Real Estate Boom? The Boom Will Not Bust and Why Property Values Will Continue to Climb Through the End of the Decade – And How to Profit From Them2. You can still buy the book on Amazon if you fancy a laugh – although of course it would have been no joke to anyone who bet on US residential property just before the crash.
A long history of bad forecasts
Of course, spectacularly bad forecasts are not a new phenomenon. In 1894, for example, the reliance on horse-drawn transportation led The Times newspaper to predict that by 1950 every street in London would be buried 9 feet deep in horse manure3. Two years later, Karl Benz was granted a patent for a petrol powered automobile and the citizens of London were spared. A much less amusing, but equally inaccurate, forecast was made in 1929 by the economist Irving Fischer, who declared stock market valuations to have reached “a permanently high plateau” less than a week before the U.S. stock market crash4. The Dow Jones industrial average subsequently lost more than 85% of its value and would not return to its pre-crash heights until November 1954.
Little better than guesswork?
But now, with access to computing power unthinkable even a few years ago, surely our ability to predict the future has improved? Unfortunately the evidence suggests we are as bad as ever. For example, in 2005 an American academic, Phillip Tetlock, published a book, Expert Political Judgment, in which he presents the results of a 20 year study tracking the predictions of 284 political or economic forecasters.
In all, Tetlock checked the accuracy of over 80,000 predictions and found that they only marginally beat predictions made by assigning equal probabilities to all outcomes5. Or, as Tetlock himself put it, the experts’ predictions were not significantly better than those that could have been made by a “mindless, dart-throwing chimp”.
Boom, bust, or neither
Another particularly rich data set comes from the Survey of Professional Forecasters (SPF), a quarterly poll conducted by the Federal Reserve Bank of Philadelphia, which asks respondents for both their estimate of GDP growth for the subsequent three years and an estimated probability that GDP will fall within certain ranges.
Source: ‘Realistic Evaluation of Real-Time Forecasts in the Survey of Professional Forecasters’, Research Rap Special Report. Tom Stark
The accuracy of the SPF forecasters was analysed in a 2010 study by the Federal Reserve Bank themselves. The study is a few years old, of course, but we consider it to illustrate clearly how little economists know about the future.
What the chart shows is that at the beginning of 2010 the SPF was 80% certain that the future GDP growth rate would fall within the shaded area. In other words it was saying that the U.S. economy would either experience a mild recession, a spectacular boom or something in between. If this sounds like a meaningless prediction, that’s because it is.
We don’t include the examples mentioned above in an attempt to incite ridicule – each of the people making the predictions was no doubt very bright, an acknowledged expert in their field and making their forecast in good faith. The future is inherently unpredictable and if we made forecasts ourselves they’d surely be no better, which is why we don’t try. But why, then, do so many people persist in attempting to guess the unknowable? One plausible explanation is they don’t actually realise just how bad their predictions are.
Tetlock’s study also found that, when asked after the fact, the forecasters remembered themselves being right more often, with a much higher degree of confidence, than was actually the case6. This effect is known as ‘hindsight bias’. Or perhaps human beings just find it too uncomfortable to admit they don’t know what the future holds? We crave certainty, and for many people a forecast seems the best way to provide this – regardless of eventual accuracy.
Finding another way
Whatever the reason, in our view investors must realise that relying on forecasts, or even making their own, is not only a waste of time but can distract from real analysis and distort perceptions of risk.
If forecasts are of no use, what is the basis on which we think investors should make decisions? Fortunately there are many investing strategies that don’t put forecasting at the heart of the process. For example, strategies that revolve around buying lowly valued stocks relative to trailing earnings (rather than forecasted future earnings) have historically been shown to outperform the market over time7. That’s the model that we try to follow in our portfolios.
Our favoured methods for filtering our investable universe down to exclude those that are unattractively valued is to use screens; we use a Graham and Dodd screen and a Greenblatt screen in tandem. The former looks at average company earnings over the last ten years (a decent approximation of a business cycle) and uses that as a reference point for the current share price. We consider stocks that currently trade on less than 16 times their ten-year average earnings. The Greenblatt screen is similar, but also takes into account the company’s return on operating assets, which is a way of considering the best combination of low valuation and high potential returns. The result is that we’re left with a collection of stocks that broadly meet our investment criteria, at which point the more detailed analysis begins.
The only prediction we’re prepared to make is that we believe the most lowly-valued stocks in the market have a better than average chance of outperforming over the long term. This has been statistically proven to have happened in the past and we believe this long-term relationship will hold into the future. With that in mind, we see that our role as fund managers is to do the research and due diligence, then construct a portfolio of lowly-valued stocks that we believe are best able to deliver on that potential. In such a complex world, we think that’s a refreshingly simple goal.
For more information visit jupiteram.com.
1Ezra Solomon was a Professor of Economics at Stanford University and a member of the Council of Economic Advisors during the Nixon administration. The quote comes from Reader’s Digest (1985).
3‘From Horse Power to Horsepower’, Eric Morris -Access magazine, (Spring 2007), p. 2-9
4New York Times, Oct 16th 1929, p.8 (Fisher also reiterated these comments in a speech before the District of Columbia Bankers Association on October 23, literally the day before ‘Black Thursday’).
5Expert Political Judgment, Phillip Tetlock P.49-54
6Expert Political Judgment, Phillip Tetlock P.137-141
7DrKW Global Equity Strategy Research, 28th June 2005
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