Around this time of year, a full field of foolish forecasts find their way to the public. Analysts, economists, strategists all roll out their various “Outlook for 2018.”
I have been pointing out how silly this process is for a long time. It is nice to see bigger firms and mainstream economists starting to come around. UBS Chief Economist Paul Donovan, in a note this week, takes some of his brethren to task:
“Economists should not make forecasts.
December always has a rash of economic forecasts for the year ahead. The reception areas at CNBC and Bloomberg TV are crowded with mobs of economists fighting to get their forecasts on air. But there are big problems with making precise economic forecasts.
Economic models are not precise. Models use lots of assumptions. Those assumptions may not turn out to be true. Models give a range of possibilities rather than a single, certain number. Economists know and understand these issues. However, the world of hashtag economics does not allow for all of this to be explained. It is difficult to warn about possibility ranges and underlying assumptions in 280 characters. This is why economists should not use Twitter (follow me @PDonovan_Econ). Economic views often give a false sense of precision, because the reporting of economics is simplified and shortened. That precision simply is not there, in our view.”
We have repeatedly referenced George Box’s famous statement “All models are wrong but some are useful.” What Donovan is referring to is a similar idea — models are lacking in precision, and are built upon assumptions. If we recognize their inherent limitations, however, they are useful.
Despite creating an imperfect depiction of the universe, they let us wargame various outcomes, playi with inputs and variables, create a series of potential outcomes. If we understand this process, we generate for ourselves a much better understanding of future potential outcomes. This is as true for what the economy might look like as it is for expected returns in the markets.
Market participants run into trouble when they forget these things: they fail to closely examine their assumptions; they do not consider the probabilistic range of possible returns; they ignore how much variability and randomness is in future outcomes.
More on this topic tomorrow . . .
What can we forecast about next year?
UBS, 11 December 2017