If These Guys Can't Get Predictions Right - What Chance Do You Have?

"The best way to predict the future is to create it"

- Peter Drucker

The Fed.

Think of the brain-power, the computing muscle, the insight, the sheer vested interest the Federal Reserve, as guardians of the monetary policy of the richest country in the world, must have at its disposal to make economic forecasts . . .

Now consider how wrong those forecasts have been.

Dr. James Bullard, President of the St. Louis Federal Reserve Bank, spoke Friday before the CFA Society of Chicago. Central to his presentation, Ghosts & Forecasts, was an explaination of how FMOC forecasts are made, and how (in)accurate they have been in the last few years. The Fed's mandate focuses on two measures - employment and inflation. Consider inflation:




 The FMOC has undershot inflation for the last two years - after overshooting it in 2011. Even using its broadest predictor, the Fed was right only twice in the last six years.

Bullard's caveat is that, like Ebeneezer Scrooge and The Ghost of Christmas Present (The Ghost in the presentation's title), their mandate is to predict that which will come to past if the present course is unaltered. The Fed's job is to do that altering if call for, but consider that the Fed's inflation policy target was higher than their highest prediction even. Scary to think how off they would have been if they hadn't been driving policy at the same time.

Unemployment predictions were a little better, only missing half the time and only about as dismal as private forecasts (small comfort). GDP forecasts have been more accurate the last two years.

Click here for the entire presentation

All financial decisions involve prediction, explicit or implicit, yours or someone else's. Because they are part & parcel of portfolio allocation, it's important to recognize their limitations and to temper your reliance on them coming true. This is why you save as much as you can. This is why it is wise to avoid 'sure things' - they don't exist. This is why diversification is prudent move. Because if the Fed can't get economic predictions right, if 'Blue Chip' economists can't forecast employment, are you going to bet your future on your or your broker's guess?

The Problem with Analysis

Oil's down. Now what?

In last quarter's Advisors' Outlook I highlighted the recent resurgence of domestic energy production as a long-term trend with unknown ramifications as far as the U.S. economy was concerned. OPEC responded by attempting to force U.S. production into unprofitable territory by maintaining the status quo on production levels in the face of lagging demand. The result has been oil prices below $50/bbl and gas prices that start with a '1'.

I would have thought this would be a good thing for the economy and markets. Except for the oil producers and support services, oil is in input cost for everyone else. A decline in the cost of production should result in higher profits or pass-through savings to the ultimate consumer. Good things, right?

And lower fuel costs should free up a piece of the consumer's budget to stimulate the economy elsewhere. People may use low cost gas to shift to bigger vehicles eventually, but in the short run demand is fairly inelastic - I'm not going to change my commute weekly as gas prices change. (This argues against lower oil prices being disinflationary as well. Though technically correct, the big worry of disinflation is that consumption slows while consumers wait for prices to fall further. I don't know about you, but I pretty much pay what the pump says when I'm on 'E' - up or down).

So why did the market fall nearly 2% on Monday with 'dropping oil prices' pegged as the culprit?

The mixed picture is confounding investors. The Standard & Poor’s 500 Index of U.S. equities fell 1.9 percent on Jan. 5, the biggest decline since October, as oil brought down energy shares and stoked concerns that global growth is slowing. - Bloomberg

I have no idea. Honestly, I still think benefit accrues to the consumer short term and long-term production trends favor the U.S., but the markets think otherwise. Or at least they did on Monday. Incidentally, an Oxford Economics, Ltd. analysis in the same article, agrees with my favorable assessment, at least about U.S. GDP.

As an investor, this leaves me in a bit of a pickle. Either:

1. My analysis (on this point at least) is wrong -or-
2. Conflicting analyses make it hard to figure out who is right

In either case, I'm better off with a strategy of a targeted asset allocation, letting the markets tell me when to buy or sell through rebalancing. The alternative is to identify someone who is a crack analyst, but for that to work, you have to identify analysts skilled in all aspects of the economy and know to balance their respective inputs. Not easy (or cheap if it truly exists) either. 

For timing to work you have to have accurate predictions, accurate analysis, and the market has to eventually agree with you. Best to avoid timing at all.

For the full Bloomberg article, click here.

Profit Is Win-Win

"Just as in physics, there were laws in the world of economics. The most basic was that when one person profited, another person did not." - "The Crown's Vengeance", Andrew Clawson.



Boy, you try to lighten up your reading for the weekend (I've not finished it yet, but pretty intriguing so far), but end up writing a blog post on the nature of economics.

The sentiments expressed in that opening quote could not be more wrong. I won't address the first sentence here today (if only economics were a predictable as physics!), it's the second that cannot stand unchallenged.

Despite being a popular theme in partisan rhetoric and entertainment, in the absence of fraud or coercion, the exact opposite is true. In every transaction, both parties profit. An example:

You buy my used 2007 PT Cruiser for $3,000. I have profited because I desire $3,000 cash more than the car. If I didn't, I would not sell it to you. Conversely, you value the car more than any other goods or services you can obtain for $3,000. If there was something else you valued more, you were free to go buy that with your cash. If each of us were not better off, if each of us did not profit from the transaction, there would be no transaction.

Well, you say, I've got to buy this car so I can get to work but I'd much rather spend that $3,000 on vacation in Destin next month. This is a crucial difference between wanting something and valuing something. As adults, we're free to choose between these two options and live with the consequences.  If you do truly value the vacation more (including the negative value of not being able to get to work because you don't have a car), you're free to book your trip, but again in that case there would be no transaction.

But, you say, I can't shop around for a better deal - I don't have time. In that case, you've already profited from the value of the free time you gained by not taking the time to prepare for the eventuality of needing to buy your next car. Anything extra you pay is for value you have already received.

What if it breaks down, or gets T-boned on the way home? Where's my profit then you ask. The agreed-upon price already takes into account the probability and negative value of adverse contingencies (or the cost to mitigate them). Trust me, if the average '07 Cruiser is selling for $3,000, I'm not selling mine at that price if I knew for a fact it would never breakdown.

Yes, you may want to spend that money on something else, you may get buyer's remorse, it may breakdown, you may find it cheaper elsewhere later, but at the moment a deal gets done both sides profit. Always. Multiply that millions of times over and see how wrong viewing economics as a zero-sum game really is.