Yet more evidence on the folly of forecasting, or why we don't need economists!

First a quick comment on the change of colour scheme. Multiple readers have told me that they struggle reading the white font on a background. To make life easier I have switched to this format. Let me know if this is easier on the eye - design never was by strong point!

One of the seven sins of fund management (section III of Behavioural Investing) concerns the folly of forecasting (Chapter 9). This is our obsession with trying to forecast the future. Yet there is an enormous amount of evidence to suggest that we simply can't forecast with any more accuracy than a coin toss (a frequently we perform worse than even chance!).

One of the papers that didn't make it into the Behavioural Investing book (but with hindsight perhaps should have been added in) was on the performance of economists in forecasting recession. In it I pointed that economists are simply hopeless when it comes to forecasting recessions (I could have stopped that sentance before the word recessions).

Their track record is truly appalling. The chart below shows that in recent history (1980 onwards) the consensus of economists has not managed to forecast either of the recessions that have occurred. The data for this charts from the Philly Fed Survey of Professional Forecasters.




In the past I have proposed that simple quant models often have the edge of human judgement (see Chapter 22 of Behavioural Investing). Some new research by the San Francisco Fed shows that my supposition that economists would be no different than many other fields in finding their subjective forecasts outperform by a simple model was correct.

In a new paper Glen Rudebusch and John Williams show that a simple model based on the slope of the yield curve has significantly outperformed economists in forecasting recessions. They show that even if we use the economists own probability of recession estimate (rather than their spot forecast), the simple model wins hands down.

The chart below shows the so called anxious index, which is the economists stated probability of recession over the next four quarters. As Rudebusch and Williams state "Even at a horizon of two quarters, and certainly at three and four quarters ahead, the probability forecasts appear to have little relationship with historical recessions."

Compare these economists probabilities with the probability of a recession from a two variable model (using the level of short rates and the slop of the yield curve). The economists say their is currently a 19% chance of a recession in the next 4 quarters, the simple model says it is closer to a 30% probability.



Of course, economists have been aware of such simple models for many years. But this begs the question why they don't use/follow them? My own answer is overconfidence. This seems to be supported by the Rudebusch and Williams paper which concludes "It is interesting to note that many times during the past twenty years forecasters have acknowledged the formidable past performance of the yield curve in predicting expansions and recessions but argued that this past performance did not apply in the current situation. That is, signals from the yield curve have often been dismissed because of supposed changes in the economy or special factors in‡uencing interest rates. This paper, however, shows that the relative predictive power of the yield curve does not appear to have diminished much, if at all. "

Yet another example of just how poor forecasting really is. We need to find a better way to invest than relying upon our disproven and discredited forecasting abilities.