| 11 May 2010
The Limits of Forecasting
I believe it is important to note that we do not really want to get in the game of forecasting. We realize that whatever we say, that is what people are going to claim we are doing. The fact is, people are terrible at forecasting. We do not consider ourselves as exceptions, especially when it comes to the economy.
The economy is a product of untold millions of individual decisions that we can have little or no insight into. Then we have the variable of government policy. As the last two weeks in Europe have shown, that is a big variable. Once governments act, it is hard to say exactly how they will carry out a policy, whether the policy will work, what the unintended consequences will be, and how markets will react. Will they concentrate on the immediate relief? Will they act based on what they think should happen, or how they believe other people will behave? Will they concentrate on longer term implications of those actions? Finally, the economy is also a system that refuses to act in a straightforward manner. It is a complex adaptive system. One thing affects another in a tangled unknowable manner.
This may seem a strange admission, considering that we have had a good streak of warning about the economy and the markets over the last decade. We also do not wish to come off as falsely humble on this score. Rather, we believe it is important to understand what it is we are really doing.
We are making educated guesses.
Oh, we have our moments of near certainty. We relish them, as they are rare. However, when it comes to the economy what we are really doing is making educated guesses about:
- The potential risks
- Potential scenarios
- Poking holes in others certainty that might mislead us, and you
- Having a bit of fun
We actually believe that valuation, or the price you pay, is far more important than any opinions we have about the state of the economy. In fact, where we see predictive value, it often runs the other way. The likely risks in markets inform our views on the economy.
We do not, and I repeat, do not base our investment strategy on our views about the economy, except at the margin.
So where can our economic outlook help us?
It can help us identify potential risks and possible insurance against them that we need to consider (these are examples, not recommendations)
- Is there cheap insurance available to offset some or all of those risks? (ex. emphasize Quality, avoid banks)
- Even better, can we cheaply take advantage of them if they occur? (Ex. Gold or TIPS to profit from and hedge inflation)
It can help identify areas where we can afford to concentrate a bit:
- Is there fundamental long term demand that warrants some extra exposure (ex. Energy)
- Is there a growth element likely to lead to higher than typical returns (ex. Emerging markets)
We pay the most attention at extremes, when coupled with overvaluation. The biggest economic risks flow from overvalued assets, or bubbles. The more overvalued, and the more types of assets that are in bubble territory, the larger the chance of a severe economic trauma. Recessions lead to larger market losses, which strains the economy even more.
The price you pay for assets however is the primary determinant of longer-term returns. Most of the time the economy plays second fiddle, and exactly how it will do is possibly irrelevant. However, it is still fun to talk about.