Counterpoint for Peter Bernstein Theory

Financial analysts are professional forecasters. But why study the economy, a traditional lagging indicator, if you want to forecast investment measures? The investment record of this process is only rarely better than random and when you take account of the expenses of achieving these results, they come out a little bit less than chance. Why do it at all with that unconvincing record of success?

Economic forecasts are supposed to be meaningful. But if you believe that asset prices reflect a forecast of future outcomes, it would seem quite difficult to use a technique that reaches back into the past to get an idea of the future. But that is what economic forecasting does. It is teased for forecasting three recessions for every one hat actually happens. No wonder it is called the dismal science.

Financial Times economics columnist Sir Samuel Brittan makes a pointed reflection on the practice of forecasting: ''The golden rule for economic forecasters is: forecast what has already happened and stay at the cautious end. Forecasts tell us more about the present and the recent past than about the future."

Poor methods, bad models and inaccurate data are all blamed for the recurrence of serious forecast errors. But according to Oxford economics professor David Hendry, these are not the primary cause of systematic mistakes. Rather, unanticipated large changes within the forecast period are the culprit. The primary fault of economic forecasting is in not rapidly adjusting the forecasts once they go wrong.

Hendry uses an analogy from rocket science: a rocket to the moon is forecast to reach there at a precise time and location, and usually does so. But if it is hit by a meteor and knocked off course or destroyed the forecast is systematically badly wrong. That outcome need not suggest poor engineering or bad forecasting models and certainly does not suggest that Newtonian gravitation theory is incorrect.

Peter Bernstein and Economic Forecasting

Despite the pressures for early and often forecasts, a number of Wall Street and City economists do as good a job as any forecasters, among them Abby Joseph Cohen, Stephen Roach and Edward Hyman. Most such investment economists are good students of market conditions careful keepers of useful data, and on occasion creative in extracting some kind of signal out of the noise. Ed Yardeni, for example, the chief economist at Deutsche Bank Securities, turns his website into a cyber-chart room. If you want to access data and view charts, Yardeni's site is an essential stop. He also makes his commentary available in a section for clients that is password protected, but a substantial amount of the content is openly accessible.

One economic commentator stands amid the few that many of us would class as the best: Peter Bernstein. He grew up heading his father's investment firm, Bernstein MacCauley, in New York. He was the first editor of the Journal of Portfolio Management, founded by Gilbert Kaplan, and has received many awards, among them the
highest honor granted by the investment management industry's professional body, the Association of Investment Management & Research.

Bernstein is able to walk on both streets with practitioners and academics. He writes a newsletter, Economics and Portfolio Strategy, to test and disseminate his analyses. And writing is one of his main strengths: his two books on the history of risk and on how capital ideas came to Wall Street have been regulars on the business best-seller lists during the 1990s.

Like a good academic, Bernstein marshals all the arguments, especially those that are counter to his own position. His mid-February 1998 letter, for example, examined the case for exuberant stock prices in the United States, giving particular emphasis to the market's reliance upon an all-knowing Federal Reserve for economic management. Bernstein concluded that "stocks are a risky investment and should be managed accordingly." Since that analysis was approximately the same as his November 1997 conclusion, he was ahead of the wave and for the right reasons. Bernstein is also faster than most to admit where he has been wrong and to try to examine what led him astray or, as he jokes, "what led the market astray when it failed to act the way I thought it would."

Understanding Economic Forecasting

Almost every financial services firm has an extensive economic forecasting effort. It is usually part of a so-called top-down investment process, which starts with an outlook for the economy and monetary conditions, continues to the strongest industries, follows with detailed company study for stock selection and may include an overlay of technical analysis to provide a timing dimension. Some would add analysis of social and political conditions even before economic studies (see Politics and Investing).

Economic forecasts derive from models usually of the aggregate national or global economy, but sometimes of parts of those economies: particular industrial sectors, regions of the world or even single products or firms. Basic approaches to forecasting simply extrapolate the past; more sophisticated models attempt to understand the sources of past changes and build them into their forecasts. The latter requires knowledge of economic history and economic principles, though, even then, forecasting is by no means an exact science. But while the accuracy of economists' predictions is frequently a target of jokes, forecasting remains a popular pursuit.

Forecasts for the macroeconomy are published regularly by academic institutions, thinktanks, governments, central banks and international organizations like the OECD and the IMF. In these places, modeling can, to a certain extent, be conducted free of the constraint of producing quick and usable data on a daily basis. But in the investment world, forecasts are required to be done early and often. A relatively short-term outlook is normally the limit of their aspirations what will happen to interest rates within the next month? with decision-makers demanding rapid output that they hope will be directly relevant to their immediate problems.

Much of the output of financial market models is naturally closely guarded in the hope that it may bring advantage to its owners and their clients. But, at the same time, investment economists like to maintain a public profile for marketing purposes, and are often called on by the media to give their opinion on the latest macroeconomic developments. Their interpretations of economic data may give some clues as to how the financial markets will react, though more often than not, they are explaining why the markets have already reacted as they did. Invariably too, there are disagreements about what various indicators mean, depending on different beliefs about the economy, and whether the firm is taking an optimistic or pessimistic view of the markets.

Each month, the Economist polls a group of financial forecasters and calculates the average of their predictions for real GDP growth, consumer price inflation and current account balances in a variety of countries. More specialized services like Consensus Economics survey over three hundred economists each month and offer details on average private sector predictions.