Forecasting 101

LONDON — “We’re paying the guy five grand a month for macroeconomic forecasts!”

My contact was livid. I was amused.

We both agreed his firm was pouring money down the drain.

In a moment I’ll share with you what the insiders say about economic forecasting.

Let’s take a quick look at the markets first.

To be honest, not a great deal to report at the time of writing. The great post-Fed relief rally in stocks remains conspicuous by its absence. Oil’s showing a bit of strength.

In other news, our international readers may be interested to know that today’s big UK political story revolves around what David Cameron did or did not do with his genitals and a dead pig’s mouth.

Google ‘piggate’ if you don’t believe me.

“The first thing you need to know about forecasting is…”

Assuming you’ve resisted the lure of scandal, let’s get back to the tricky task of predicting the future.

Let me take you back to my first university lecture on forecasting. It was the most important tuition I ever had on the subject.

“The first thing you need to know about economic forecasting,” the lecturer said, “is that it doesn’t work.”

Cue murmuring in the lecture hall.

“You can’t do it. Doesn’t work.”

More murmuring.

“But… because many of you will get jobs where you’ll be required to do it… and because some people will pay you very well to do it… I’m going to show you how it’s done.”

Nervous laughter.

“I’m also going to teach you what you should say when it doesn’t work, which inevitably will be the case.”

Several weeks of algebra followed. We learned why simple models often work better than more complex ones.

We learned how apparently small changes in assumptions can make a big difference to your forecast. We picked up techniques to help us judge how effective our methods were.

But nothing we learned was as valuable as the secret knowledge gained from that first lecture: this doesn’t really work.

It’s the Planning, Not the Plan, That Matters

So why do economists bother?

A cynic would say they just do it for the money. That’s not entirely fair – although, as in the case of the guy reportedly charging five grand a month, it obviously goes on.

There’s a quotation attributed to Eisenhower: “In preparing for battle I have always found that plans are useless, but planning is indispensable.”

Several decades earlier, Hemluth von Moltke, chief of the Prussian general staff, said something that today is quoted as: “No plan survives contact with the enemy.”

Your forecasts will be wrong. So will mine. So will five-grand-a-month guy’s.

But the process of trying to forecast can nevertheless be valuable. It makes us think about what the key factors are, and rank them in order of importance.

This gives us something to test against new information when it comes in. It also highlights areas of informational weakness, and serves as a reminder of how little we know.

Handled with care and humility, the tools of the forecaster can help us make better decisions.

Sadly, though, too many people want to outsource their thinking to someone else. They want the empty calories of a single number forecast, while skipping the nutrients contained in the process.

They want the plan – they’re not interested in the planning.

An Alternative Approach

There is an another approach. One we use in our monthly investment newsletter Strategic Intelligence.

One big thing I have in common with Jim Rickards and David Stevenson (my colleagues on the newsletter) is we all appreciate the value in the planning, not just the plan.

Jim will draw up alternative scenarios, then use new data to update his view on which are most likely. Indications and warnings, he calls it, a term he picked up from his time with the US intelligence community.

Sure, Jim will make calls on macro topics. The real value forStrategic Intelligence members though is in the rationale, which helps them in their own decision making.

David meantime is a hardnosed value guy. He looks at companies objectively, and forms his own view on what they’re worth independent of what the market is saying.

We can only begin to prepare for the future properly once we accept we can’t forecast it with any great accuracy.

If you agree with that, you should look into joining us.

Find out more here.

Until next time,

Ben Traynor
for The Daily Reckoning, U.K.

P.S. Be sure to sign up for The Daily Reckoning — a free and entertaining look at the world of finance and politics. The articles you find here on our website are only a snippet of what you receive in The Daily Reckoning email edition. Click here now to sign up for FREE to see what you’re missing.