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How Useful Are Economists' Predictions?

Sep. 10, 2020 2:07 PM ETSPDR® S&P 500 ETF Trust (SPY)
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  • Empirical evidence is underrated.
  • The loudest voices are often the least informed.
  • Traders should focus on persistent relationships.

US Coincident Economic Index

Pragmatism Wanted

Economists have a dismal track record of predicting the future. Economic theory is largely divorced from reality and much of it ignores the boom bust cycle.

As a result, the majority of the 153 recessions that occurred around the world from 1992 to 2014 completely surprised economists, according to research from the IMF.

Potential Causes

Incentives inspire economists to follow the herd. If they argue a popular view that turns out to be false, few critics will cry foul, but if they argue a contrarian view that turns out to be false, media and colleagues are more likely to pounce. If their contrarian view ends up being right, they receive only moderate benefits.

Many economists place a low weight on the information in asset prices despite the large body of evidence showing their predictive value. Economic models sometimes fail to determine how unpredicted events, like natural disasters or drastic policy shifts, change an economy’s trajectory. Popular economic variables, like GDP, are often lagging indicators and come out months after the fact. Forecasts may lack “street smarts,” ignoring qualitative factors like corruption, unrest, and illegal markets.

Like most humans, economists dislike admitting that their initial predictions were wrong. When new information changes the situation, they only make slight adjustments to their initial beliefs so they can still feel like they were right. In contrast, legendary investors like Druckenmiller, Sperandeo, and Minervini have stressed the importance of flexibility, impartiality, and being unafraid to reverse your views as more facts emerge.

Overall, though they offer insights on present conditions, economists fail to predict the future and usually under-anticipate it, assuming that the present trend will continue.

Implications for Forecasting

Forecasters should observe reality and study history instead of exploring intriguing theories that lack predictive power. By focusing on empirical evidence, traders and investors can filter out the noise and focus on statistically significant patterns and relationships.

Sophisticated theories are fun but rarely worth risking capital on. Since most theories don’t pan out, investors can avoid unneeded losses by only risking capital in situations where price action (investor sentiment) is starting to agree with their thesis.

For more insights on investing and forecasting, checkout Stock Savvy

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