The Foolishness of Forecasting

“Prediction is very difficult, especially about the future” – Niels Bohr, Danish physicist

“…the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” – Benjamin Graham, value investing “Dean”

Warren Buffett, probably the most successful investor alive, doesn’t make earnings forecasts.  He doesn’t do what every MBA student is taught: build a model that forecasts future earnings over time.  That doesn’t mean the future isn’t important to him.  Quite the contrary.  He is obsessed about the future!

But, that doesn’t mean he makes forecasts.  Why?  Because forecasting is notoriously difficult.  The records of various forecasters, whether historians, economists, political scientists, financiers, social scientists, and, especially, government bureaucrats, are terrible!

My own record here is exhibit #1.  I like to forecast political and social outcomes, but my forecasting record is as dreadful as everyone else’s.

But, isn’t successful investing about forecasting the future?  Doesn’t one have to know what sector of the economy, which asset class, etc. will do best?  No.

In fact, the records of those who try to do the above are as poor as everyone’s.  Those selling such forecasts want you to believe the future can be forecast, but if they were any good at it, they’d be making a fortune doing it instead of selling forecasts. 

I can guarantee you, knowing the future would make you rich.  But, that makes the rather huge assumption that you can do it successfully.  I’ve never met or read about anyone who can.  Like ESP, tons of people seem to think it’s possible, but when submitted to scientific testing, proves lacking.

So what does Warren Buffett do?  He studies the historic record intensely so that he understands a company, its industry, its competition, its competitive advantages and threats, its management, etc., then he pays a cheap price relative to that historic record. 

He doesn’t forecast earnings growth explicitly, but he does buy businesses with a record of growth and with all the expectations of future growth behind them.  Its a qualitative rather than quantitative assessment. 

Most importantly, he doesn’t pay for future growth.  The price he pays has a margin of safety, rendering an accurate forecast of the future unnecessary.  If he pays a low enough price today, he’ll get an acceptable return no matter what.  If growth continues, and he spends gobs of time focusing on this qualitative aspect, his return will be better–perhaps much better. 

That’s it.  No magic flutes, no crystal balls, no whirling dervishes.  Just understand intimately a particular business (and no one understands what makes businesses tick like Buffett), pay a fair price for it, and let the qualitative tailwinds blow you on to wealth.

This is very contrary to what most investors, both professional and individual, do.  Most investors spend the vast majority of their time trying to figure out what the future holds instead of studying the past and present with the same intensity.  They make elaborate models with spreadsheets to forecast all the potential variables to the fourth decimal place.

The result isn’t just that they don’t understand the important variables of the past, the result is forecasts that are notoriously bad. 

The average Wall Street analyst over-estimates business growth by 50% (businesses they study with great intensity and with unique access to industry insiders). 

The average economist considers himself a hero if he gets the DIRECTION (not magnitude) of economic variables correct, and almost always miss major turning points (they have models of such mathematical complexity that physicists are intimidated by them). 

I could go on, but you get the point.  Forecasting is a dead end.

Contrary to all investing lore and conventional wisdom, this does not suggest broad diversification.  Don’t get me wrong, diversification is the right way to ride economic growth at minimum cost.  But, if you want to do better than that, you need to concentrate on the very few things you can understand better than others. 

As you may have guessed, that’s an understanding of the past and present, not a brilliant forecast of the future. 

If you study every cell phone company in great detail from quarter to quarter, and understand each of their technological, managerial, competitive, economic aspects, and you realize that one stands head and shoulders above the others, yet is selling at a very reasonable price, you may have a good investment.  If, on the other hand, you recognize that the technological or competitive dynamics are such that you can’t figure out who is and will stay on top, then you should move on to an industry where you can.

A tremendous amount of study and intellectual honesty is required to do this, but so few put in the effort that thar’s gold in them thar hills.

Don’t forecast.  Study intensively the past and present, and pay a low price.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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The Foolishness of Forecasting

Interesting indicators

I don’t put a lot of faith into watching economic indicators. They seem to tell you more what has happened than what’s going to happen.

On the other hand, I do watch a couple specific industry indicators that do, in general, give me a flavor of what may be going on economically.

For instance, the price of copper is an interesting indication of worldwide demand for basic materials. Copper goes into so many things that watching copper prices gives me an interesting view into overall economic growth. Copper prices peaked in late August and have been holding relatively steady below that peak.

I also watch the price of oil and natural gas. Oil and gas are also fundamental inputs to many types of production, so watching their prices is also informative. Oil prices, which reflect global demand, peaked in early August and have been trending down. In contrast, U.S. natural gas prices, which reflect local demand, bottomed in late August and have been trending up.

The Baltic dry index, which reflects worldwide dry bulk shipping rates, bottomed in late September and have since climbed over 20%. This indicator lets me know how much shippers are charging to move large amount of dry bulk materials, like wheat or iron ore. When shippers are charging higher rates, worldwide demand is up.

Each week, the Association of American Railroads reports rail traffic for the U.S. and Canada. This indicator shows how many rail cars of containers, coal, bulk materials, etc. are moving around North America each week. This indicator recently peaked in early September and has been trending down over the last 4 weeks.

Add it all up, and what do you get? A mixed picture.

Copper prices are down only slightly. That could be due to higher copper production, lower demand, or some combination. It’s not a very bullish sign.

Oil prices are down, too, and this reflects global demand for a fundamental input to everything. This is also a bearish sign.

Natural gas is climbing again, which seems to be bullish for U.S. demand, but it could also reflect the huge slowdown in natural gas production that has occurred over the last year.

The Baltic dry index is up, which seems bullish for global demand. It could also reflect that global shippers are on the ropes with high debt loads.

Railroad traffic is down in the U.S., which seems a bit bearish, but seasonal factors may be impacting the numbers and traffic isn’t down by a large amount.

Do you see why watching economic indicators can be problematic. There are no obvious blinking lights and ringing bells. That’s part of the reason why economic forecasters and market strategists have such a lousy record of predicting even the direction, much less the magnitude, of markets.

One of my favorite jokes is that market strategists (who forecast market direction) are like diapers; they need frequent changing and for the same reason.

It looks like global demand may be doing better than U.S. demand. But, then again, maybe not.

That’s why the smartest thing to do is buy great companies at good prices or good companies at great prices and just ride the market up and down. It works.

Market and economic forecasting? Not so much.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.