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Paper Tigers

Adam M. Grossman  |  December 23, 2018

I RECENTLY received some odd communications from mutual fund giant Vanguard Group.

First, it sent a white paper, “Here today, gone tomorrow: The impact of economic surprises on asset returns.” As the title suggests, this paper examines the relationship between the economy and the stock market. In particular, the authors asked whether accurate economic forecasts could help an active trader profit in the stock market. Their conclusion: To beat a simple buy-and-hold strategy, an investor’s predictions would need to be accurate 75% of the time. They then address the question that naturally follows: “How achievable is a 75% success rate?” The paper’s answer: “Not very.”

That was the first paper—and its conclusion seemed entirely logical: Don’t bother with your crystal ball, because it’s highly unlikely to help you beat the market.

Then the second paper arrived: “Vanguard market and economic outlook for 2019.” In this one, the authors provide their outlook on a variety of topics: economic growth, inflation, unemployment and much more. The paper runs more than 40 pages, with probabilities assigned to a variety of events. For example, they foresee an 18% chance that the U.S.-China trade war escalates and a 29% chance that the two countries reach an agreement.

In other words, the second paper was full of the sort of economic predictions that, in the view of the first paper, are largely “irrelevant.”

What’s going on here? Vanguard’s first paper made perfect sense. Why did they invest so much time assembling that second one—a report that, in their own colleagues’ estimation, is unlikely to help investors?

I don’t mean to single out Vanguard. At this time of year, all the big financial firms are busy issuing forecasts. Morgan Stanley sees corporate profits slowing next year and the potential for a technical recession. Credit Suisse sees the S&P 500 rising to 3,350 in 2019. And Wells Fargo projects S&P 500 profits at precisely $173.37 per share.

In short, everyone has an opinion. Is it possible that Vanguard’s first paper—the one skeptical of predictions—was the one that was wrong? If all of these major institutions spend so much time formulating and publishing forecasts, surely they must be worthwhile.

Economist Prakash Loungani has spent the better part of two decades researching the issue. In a 2001 study, Loungani evaluated experts’ ability to forecast recessions. His conclusion was blunt: “The record of failure to predict recessions is virtually unblemished.” In a follow-up study, looking at the 2008 financial crisis, Loungani’s findings were nearly identical. Economists uniformly failed to predict that global recession.

Perhaps Loungani’s study wasn’t comprehensive enough. What about all-star forecasters? Here the evidence is inevitably more anecdotal, but no more encouraging. Consider Abby Joseph Cohen, the recently-retired Goldman Sachs strategist. Her forecasts during the 1990s earned her the nickname “the Prophet of Wall Street.” But she later missed the two biggest meltdowns of her career: In 2000, when the dot-com bubble burst, Cohen predicted the market would rise. And she, along with virtually everybody else, missed the 2008 collapse.

A more recent example: Ray Dalio, the billionaire founder of hedge fund Bridgewater Associates, proclaimed in January of this year: “If you’re holding cash, you’re going to feel pretty stupid.” The year’s not over yet. But so far, cash has done materially better than the stock market, which is in negative territory.

The reality is that forecasting has always been difficult—and not just in the world of economics. Decca Records told the Beatles they have “no future in show business.” Walt Disney was once fired for “lacking imagination.” The list of incorrect predictions is long.

If forecasts are so error-prone, why do sensible organizations like Vanguard continue issuing them? In part, I believe it’s in response to investor demand: People want to know what’s going to happen and they believe experts can tell them. It’s just human nature. But now that you’ve seen the data, here’s my recommendation: Tune out anyone who approaches you with a crystal ball. Instead, situate yourself so the market’s short-term ups and downs don’t impact your ability to meet your financial goals—or to sleep at night.

Adam M. Grossman’s previous blogs include What Matters MostHappy Compromises and Pushing Prices. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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