NEW YORK (TheStreet) -- "Economists have correctly predicted 11 of the last three recessions," quips a comedian. Sadly, that's true. Forecasting is not a lost art; it's an abstract art, subject to models (which may be capturing incomplete or inaccurate data), logic (which may be faulty), and guessing (particularly when forecasting unprecedented events).
Indeed, history is replete with numerous gaffes that go well beyond explanation. Just recently,
surveyed 85 economists about the June 2011 Labor Department payroll report. The economists forecasted that payrolls would increase anywhere from 60,000 to 175,000 persons. It turns out that only 18,000 people were added to payrolls; not a single economist came close to the actual figure.
Meredith Whitney made a name for herself in 2008 by forecasting that Citigroup would cut its dividend and incur severe financial distress well before that view became conventional wisdom. Her more recent call that the municipal bond market could incur 50 to 100 sizable defaults this year that will amount to hundreds of billions of dollars worth of defaults seems mis-timed, if not inaccurate.
In early 2008, both
Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson argued that the U.S. economy would not fall into a recession. They believed that the interest rate cuts made to-date by the Federal Reserve, coupled with a $170 billion economic stimulus package signed by President Bush, would address the economic weakness and allow for growth. It turns out that $170 billion of stimulus wasn't enough to keep the economy growing.
Similarly, Alan Greenspan, former Federal Reserve Chairman, caused a brief global equity market panic in December 2006 when he gave a live speech and posed the rhetorical question: "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions...?"
What's fascinating here is that Greenspan wasn't actually making a forecast. Rather, what's startling is that the global equity markets immediately plunged on the interpretation that Greenspan was indeed forecasting that P/E ratios were out of line with rational analysis. Of course, this knee-jerk interpretation of "irrational exuberance" of the equity markets in December 2006 was grossly premature given that the
S&P 500 Index
rallied 105% from 1997 to 1999.
In short, it's only natural for investors to seek clairvoyance. Everyone wants to believe in someone else, and everyone wants a "quick fix" to solve for the future. The problem is that many forecasts are ill-timed or inaccurate.
So what should you do when reading or hearing an economic forecast? Merely discard all forecasts as folly? No, not entirely, as there is hidden value in any forecast, as long as you know where to look.
As an investor, when reading or hearing any forecast, you should seek to understand the framework from which the forecast is being made. Take a look at the quantitative and qualitative factors that are being used to arrive at the forecasted result.
The actual process of dissecting the components of the forecast is incredibly valuable, as it forces you to identify the key factors that will likely drive the forecasted results, and to reconcile or discount the projected result from your own interpretation of how economic events will unfold.
Moreover, you can take these components and build upon them. What's to prevent you from subsequently creating your own forecast scenarios? You needn't develop a highly complicated model, per se. Rather, study the components of a forecast that has already been made. Are all of the key factors that will influence the investment results really being incorporated into the expected result? Are certain factors missing from the analysis or improperly weighted into the model? Should other factors be diluted or eliminated from the analysis?
In addition, bear in mind from whom the forecast is coming. Do you really expect a Federal Reserve chairman to tell you that a recession is coming when so much of economic activity is predicated on consumer confidence? Conversely, doesn't it make perfect sense to you that Wall Street equity analysts have consistently rated many more stocks as "buy" than as "sell" recommendations?
Most importantly, when trying to make heads or tails from an economic forecast, you must be emotionally and intellectually honest with yourself. That is much more difficult than it sounds. You battle fear and greed as does everyone else. When you read an investment forecast for high rates of return and a low likelihood of loss that sounds too good to be true, that might well be the case. Likewise, when your hear a forecast for global Armageddon, take a deep breath and break down the pieces of the puzzle before succumbing to the gloomy conclusion.
In all cases, when listening to a forecast, don't take it at face value. Take the time to break it down and understand its parts, to reflect upon the motivation behind the forecaster's prediction, and to determine if the conclusion reached resonates with your world view.
Alan Zafran is a partner of
, a $4 billion financial-advisory firm providing wealth-management services to high-net-worth families. He has over 20 years of industry experience, previously serving as a wealth adviser for affluent families at Goldman Sachs and Merrill Lynch. Zafran�s experiences include facilitating the execution of credit default swaps on subprime residential mortgages in 2006 and 2007 before the market crashed. He is a contributor to TheStreet, Forbes.com and Wall Street Week. Zafran received his MBA from Harvard Business School after graduating Phi Beta Kappa from Stanford University.