Crowds gather early in the morning to watch for what the future will bring.
The media are on hand for the latest predictions and run stories with sensational headlines to engage their audience.
Leading figures confer, hoist prominent prognosticators on high, and loudly sing praises about their ability to predict the future.
Beyond the Punxsutawney Phil ceremony illustrated in the Groundhog Day picture above, what I was just describing?
Every day the Street produces an endless daily stream of chatter about morning futures and estimates about the direction of the financial markets.
Unfortunately, research suggests that the wizards of Wall Street often have about as much predictive power as the Wizard of Oz and as much success in predicting the future as groundhogs.
Just as it is might be hard to resist clicking on stories about Punxsutawney Phil and predictions of warmer Spring weather, it is hard to avoid getting caught up in the emotion and allure of economic and market predictions.
As many researchers have shown, our brains have evolved to recognize patterns. This ability kept us out of trouble on the plains, but the side effect is that we are pattern junkies.
We are naturally inclined to search out patterns and to try to use them to predict the future. This can make all humans, however, think that we have crystal balls and makes us vulnerable to the psychological bias known as the halo effect – professional investors included. The better known, more intelligent sounding, or more respected an expert forecaster is, the greater the confidence we have in his or her predictions.
Never in Doubt but Often Wrong?
This old inside Wall Street saying says it all, and it goes beyond investment firm forecasts.
Even Federal Reserve Governors and their economists are poor soothsayers (see the bottom of this article for related posts and research).
Below is a quote from a report published in February of 2015 by the Federal Reserve Bank of San Francisco based on a study of the Federal Reserve Open Market Committee’s Summary of Economic Projections (SEP):
“Over the past seven years, many growth forecasts, including the SEP’s…, have been too optimistic. In particular, the SEP forecast (1) did not anticipate the Great Recession that started in December 2007, (2) underestimated the severity of the downturn once it began, and (3) consistently over-predicted the speed of the recovery that started in June 2009.”
Yes, you read this correctly, they predicted the downturn only after it started and the recovery only after it began.
Some might say, “Well, this is not unexpected, the best minds are not in the public sector but in the private sector inside the best investment banks.”
My halo bias wants to believe this, but independent analysis of investment analysts’ estimates and projections paints a consistent picture. They are also often wrong at the wrong time.
As an example, McKinsey & Company produced a study in 2001 about the accuracy of earnings estimates, which was then updated in 2010. The following quote summarizes their findings:
“Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined. On average, analysts’ forecasts have been almost 100 percent too high.”
The chart below is from the most recent 2010 McKinsey & Co. research paper. The light green line represents Wall Street earnings forecasts. The blue line reflects what actually happened.
Like Bill Murray during his Groundhog Day movie experience, surely we’ve learned something and are not repeating things over and over the same way.
I’m afraid not.
Just as recent experience has shown weakness in political predictions, research on the accuracy of investment estimates continues to disappoint.
As an example, CXO Advisory published a report based on over 6,500 predictions made by 68 investment gurus covering the time period 1998 – 2012.
What did they find when they graded these gurus?
The accuracy of well-known investment strategy professionals, including luminaries like Jeremy Grantham and Abby Joseph Cohen, was only 47% (see the following for the complete study – Guru Grades).
Evidence suggests that market predictions aren’t worth much, but this doesn’t mean you should go into an investment hole during difficult, wintry market conditions.
If you have spent time developing a long-term plan based on your goals, and not the models of others, stay on course, or as we wrote about before, just Keep A Steady Hand On The Tiller.
Rough market shadows can make everyone feel like a groundhog, but remember that market troubles eventually thaw, and that steady long-term investors are consistently rewarded.
Fallible Forecasts? – October 2019
Prophets and Profits – McKinsey Quarterly – October 2001
Don’t Be A Sheep – May 2015