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Why Economic Predictions Always Fail Us?
Submitted by Nic Lenoir of ICAP
There is a sense when one reads sufficiently educated publications that a lot of people feel betrayed by financial and economic forecasts. One can argue whether some analysts foresaw what was about to unfold as early as 2006, but fact is most people had it completely wrong.
Financial forecasts are always tilted to the upside because overall we have a recent history of solid growth globally so our expectations suffer from positive recency bias, and also because even when the outlook is a little most negative it is in the financial services industry's best interests to spur optimism as sleeping money does generate any fees.
When it comes to economic forecasts obviously official forecasts are always tilted to the upside because it increases chances of reelection and it also allows higher spending with future high tax revenue being the offsetting entry on the accounting books. However one should expect independent economists to be much more accurate in their forecasts assuming they do not work for an employer with direct vested interest in overestimation of growth. Maybe that does not transpire because man in general is by nature optimistic. What I think is a much more interesting subject is the lack of granularity in economic analysis and statistical releases backing the analysis, whether the resulting conclusions are bullish or bearish for the economy.
Not an economist by training, I always grow frustrated when developments in forecasts don't match at all my rational understanding of what is happening in the economy. I have tried to pay more attention to it because being bearish, I was surprised by the extent of the rebound in manufacturing activity since March, and despite viewing this rebound as artificially generated by public demand or publicly sponsored private demand, it remains that statistically the releases showed dramatic improvement. At it turns out the answer I always received when inquiring was: "look at new orders", "have you seen inventory levels". A few things became obvious. First is the fact that a lot of econometric models use cycle analysis corresponding to the average duration and unfolding of the "traditional" business cycle, and the second is that a lot of projections are based on leading versus lagging indicators, but without all that much in depth digging into the reason why fundamentally the leading indicators are leading the lagging and where. As an example, many people talked about the second derivative turning in March, and in some cases ahead of time, called the turn in equities. Yet despite these timely calls, no one really convincingly at the time showed in numbers how public spending was starting to outpace the slowdown in private spending. There were people arguing that bail-out efforts were unprecedented and would lead to a turn, but they were absolutely not quantifying their arguments. So the average spectator was left with unquantified fundamental arguments and econometric forecasts with no solid fundamental arguments to back them up, and both faced a number of equally unquantified bearish arguments or even some econometric bearish projections. At the end of the day if an analysis is not robust enough then agreeing with its conclusions requires being biased towards agreeing in the first place, which renders the analysis useless.
That's why I try to stick to technical analysis most of the time, because I believe that enough understanding of the technical underpinning of the market and investor sentiment can increase odds towards a greater move one way or the other, without guarantying it will happen however. When it comes to economic analysis I have no claim of being able to provide a more quantified framework than anyone else, nor do I really have the time to. All one can do is use logic and try to analyze the research coming across one's desk, and that's my predicament.
The most shocking yet consistent conclusion I always reach, is the lack of depth of the data being presented. Take real estate for example. There is very little work done trying to provide public statistical data beyond price median and number of sales. For example how is the change in price in housing for each house not put in perspective with the price at which that house (if it's an existing house as opposed to a new construction) last sold, and when. If one month only multi-million homes traded then it would be the new median and the change in price would reflect this absurdity... Relying on only one or two numbers to describe a complex market lowers the relevance of any findings. We could also mention the number of foreclosures, the curb placed on that number, or the amount of cash spent in renovation before resale, but the point is made here. In the case of real estate it is easy to understand: there is little public resource thrown at the analysis, and private research is either costly or published by realtors, who are just as biased as financial analysts making buy or sell recommendations.
However beyond real estate, look at a statistic such has the average household income: all we get is the percentage change. That hardly tells anything at all. How is that divided across sectors or on the level of income is anyone's guess. Why is there so much focus on averages, a statistical concept that is at junior-level in terms of mathematical understanding? Don't we know how to look at distribution, multi-factor analysis, statistical relevance tests? There are billions of dollars literally gambled daily based on averages. If you look at the percentage change of the median income versus the 95th percentile income, you realize high incomes have grown since 1960 at 3 times the speed of median incomes, and I would be willing to bet that 99th percentile numbers would be even more telling. My basic underlying understanding of the economy is that the middle and lower class have had very little income appreciation over the last 40 years, if not negative growth once adjusted for inflation. That gap has been filled by a huge increase in credit which has allowed to maintain consumption, while the savings rate tanked until it became negative at one point (and that is an average, just pause and think... yes it is scary). In the meantime the amount of free money being saved at the fringe has been a huge factor in asset inflation, helped by abundant liquidity provided by governments in the Western economies. It is easy to say, and looking at income growth across percentiles one gets a first clue to quantify it, but until our statistical analysis becomes a lot more evolved, results will be very irrelevant in terms of prediction value.
Good luck trading,
Nic
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Well, if Adam and Eve hadn't eaten that apple....
Putting aside the fact that the entire economic forecasting and investment industry is one huge massive conflict of interest, the simple answer is that group think is handsomely rewarded (both financially and socially) and being contrary is not.
Yes, that's an over simplification but that doesn't mean it's not true to a very large extent.
>group think is handsomely rewarded (both financially and socially) and being contrary is not.
Except of course for the times that group-think leads the entire herd over a cliff -- at which times being contrary will save your a$$ets.
And as applied to financial matters, well when the "majority" is buying prices go up (in kindygarten we called that game "leapfrog" in recent years it has been called either "401K investing" or "Real-Estate Boom")... but, as soon as that tips and the majority freaks and wants to sell, then the other game kicks in (in kindygarten we called that game "Musical Chairs" -- and when the teacher wanted to end the game FAST, she removed half or more of the chairs at a time -- the person able to "hover" near the optimum spot relative to the few remaining chairs was most likely to be the first to sit -- SOON we will call that "Baby Boomer Cash-Out" [because "retirement ain't gonna happen] -- and while the group-thinkers are busy listening to the music the contrarian is watching the teacher's hand [cause light travels faster than sound]).
But hey... keep thinking with the group, mmmkay!
Marx got it right.
Good report NIC. Here is a key statement you make: "...The most shocking yet consistent conclusion I always reach, is the lack of depth of the data being presented..." We have always found that few on Wall Street are truly concerned about economic accuracy or originality. Rather, they have very short memories and even less work ethic. Wall Street has always been a group where it is easier to follow the herd (copy or plagiarize other analysts work) versus actually producing original analysis challenging the status quo in order to produce cutting edge research or results. Good work.
Its all about incentive structure and (perceived) risk/reward; going out on a limb, especially if it requires far more work and cajones than 'normal' is seldom seen, especially on the sell side, as a good career choice. This is why you see narrow distributions (usually) in estimates, etc, etc.
Marx got it right.
Mises got it right, and a lot of his students predicted the current situation and reaped the benefits of their accuracy.
Yeah, the real estate stats are crazy. these days the median sales price is often 1/2 or 1/3 of the mean asking price, but that's because the mean asking price is computed on houses that aren't selling, whereas the median sales price is computed on houses that *are*.
Looks like there is going to be a run on tinfoil! Do you have your hat made yet?
http://www.telegraph.co.uk/finance/markets/6259436/The-mystery-investor-...
Tin foil cat
http://riverdaughter.files.wordpress.com/2008/11/tin_foil.jpg
Ass hat
http://pix.motivatedphotos.com/2009/1/12/633673729262531831-tinfoilhat.jpg
lol
Todays "tinfoil" is made of aluminum. The aluminum supply is not affected by a shortage of tin.
Maybe the economic predictions fail because they assume a free market?
There are some numbers that are more difficult to manipulate so can give a better reflection of what's happening in the economy. Look at the earlier ZH post about New York State sales tax revenue - down 36%. Tax revenue is a hard number to "green shoot" so may give a more unblemished look at reality. I'm not saying that every state is down 36% but it would be an interesting number to search for. The problem that will keep hanging over us is debt and it's hard to get out of debt by loading on more of it.
They don't want the real truth to come out lest you see what reality is like...
if you enslave the majority of the population by forcing them to work for low wages on a never ending treadmill of debt you have a submissive society that becomes too poor and uneducated to react (until the final breaking point is reached when they cannot take it any more, like the French Revolution).
It has happened all throughout history, the rich allow this because if they didn't they wouldn't keep their riches, and they tend to be the more educated but keep their mouths closed.
That is apart from the odd brave ones like ZH who cannot stand by and let this happen.
It is a sad world that we have to rely on such a few heroes and heroines that stand up and shout out against the powers in control. They are very brave because those that do not want their riches taken away will do all the can to discredit them.
Nice article Nic. Supply and demand on the technical side is as good a forecasting method as any. Buy when that chart is low and oversold, sell when high and overbought. Reminds me of the Justin Mamis book "The Nature of Risk".
Zarnowitz used to say that economists always underestimate inflation. They always miss the positives of low inflation and can be off for a decade as we saw in the 1970s when underestimating the negatives of inflation. The whole decade, they were overestimating GDP. The indexes work but they don't know how to compare them. Negative growth rates in the lagging index is a positive for stocks and bearish for gold. The leading inflation index is also needed. Yen has been the most favored area by economics, because the Japan's long leading index and the U.S. leading inflation index both have positive growth rates. Gold gets some help from such a setup but yen is where the support is. It's hard to see the indexes gaining strength from here but holding up near such high growth rates will do wonders for yen even if the easy money has been made.
one point to consider statistically is sampling margin and tolerance....if jobs report says that unemployment is going up .5% and actual is a decline the forecast could still be correct if the sampling error is sufficiently large....no one ever asks for tolerance so both could easily be right...
and yes americans especially in the bottom 3 quintiles of income have lost ground since 1972....this is one reason why inflation is so evil - it is a stealthy redistribution of income from the have-nots to the haves....
unemployment for those with college degree or higher is "only" 4.9% compared with the u-3 of 9.8%....and that 4.9% represents a huge chunk of lost income compared to the remaining 5%....
kind of like the guys saying the dollar isnt going anywhere....
Anyone seen the drudge headline? Anyone have insight into this?
ARAB STATES LAUNCH SECRET MOVES WITH CHINA, RUSSIA, FRANCE TO STOP USING DOLLAR FOR OIL TRADING... DEVELOPING...
Clearly, if it's on Drudge then it's a DONE DEAL (tm)
fundemantals don't work in this economy, nor does history and certainly not the news. I'm also starting to suspect technical analysis since it's used by financial terrorists (FED, GS, JPM...) with their endless liquidity against those who put their trust in it.
It's like being kicked in the arse with your own foot. You think it can't be done, you've never done it before, everyone tells you you're a fool if you do and technically, it seems impossible but then you realize you're arse smells like cheese and your foot like turd.
"also because even when the outlook is a little most negative it is in the financial services industry's best interests to spur optimism as sleeping money does generate any fees."
Just a smattering of the sage advice my family and I received from our advisers (rhymes with Sandfart Burnstooge), in no particular order:
"Our number one priority is capital preservation - don't worry"
"Subprime will be a 200mm event - don't worry"
"RE market will return to peak in 2010 - don't worry"
(12/07) "We could see continued volatility for the next 3-4 quarters - don't worry"
"We have 300 analysts working to protect you - don't worry"
When I was told by a "technition" that the DOW was showing a "Black Cross". "technicals are worthless - don't worry"
"The market HAS to go up - don't worry"
(DOW 8500) "You want to go to ALL cash?! Maybe we should look at lowering your exposure to equities. That way we can take some some volatility out of your portfolio" (already down 36%).
(1/09) PowerPoint presentation from highest levels - "Our analysis says, all in". No dice, douche bag.
The "kool aid" days are over for me - long live ZH.