Economic Forecasting and Market-Timing: Stay Clear of It!
by Jay D. Franklin Friday, January 18, 2013
Anybody who watches CNBC during market hours gets treated to a litany of economic predictions and their expected impact on market prices. Quite often, you
will hear from two different pundits with opposite points of view about the direction of the economy, yet both sound completely reasonable, leaving you in a
state of analysis paralysis. IFA's best advice has always been to ignore the talking heads—invest and relax. A recent visit to IFA's media lab by Marlena Lee, a
vice president on Dimensional's Research team and an expert in asset pricing theory and macroeconomics, completely confirmed our long-held views.
IFA.tv Show 66-1
Marlena addressed the issue of economic forecasting by asking the following question: Supposing that you could perfectly predict recessions (which is beyond
the ability of even the most accomplished economists), could you profit from being out of equities during the recession? Intuitively, you would think so, but you
would be wrong. As the table below shows, since 1900, equities have produced higher-than-average returns during recessions.
1900 to 2010
Real GDP Growth
Real Equity Return
Source: National Bureau of Economic Research and The Center for Research in Security Prices.
Using data from the same two sources cited above, Marlena found that if you had engaged in market-timing during the past 19 recessions, you would have
harmed yourself in 17 of them. Marlena also showed that looking across countries, there is very little correlation between GDP growth and equity returns, so
those pundits who lament the arrival of "the new normal" of low GDP growth have no real basis for predicting lower-than-average equity returns. Recall that
equity returns are based on corporate earnings which are just a fraction of total GDP.
Economic forecasting aside, we at IFA are often asked about the efficacy of market-timing. Of course, it goes without saying that if somebody consistently knew
when the market was going to decline and when it was going to advance, they could earn an immense fortune. The problem is that nobody knows. Since
financial markets are highly efficient, all relevant information is incorporated into current security prices, and only new information (i.e. news) causes prices to
move, and news (by definition) is unknowable in advance. This explains why we have yet to see anybody who can consistently time the market (and most likely
never will see anybody who can). Nevertheless, hope springs eternal, so for those who still feel an urge to time the market, we refer them to IFA's Step 4 which
covers a study of 32 market-timing newsletters over a 10-year period, showing that not one of them beat the S&P 500 Index. My favorite part of Step 4 is the
discussion of CXO Advisory's "guru grades" that they assign to pundits like Jim Cramer, based on the accuracy of their forecasts. Their average score is a little
under 50%, which is expected from chance alone. The highest scoring among them at 68% is still not high enough to successfully profit from trading after
covering transaction costs and taxes. In case you were curious, Mr. Cramer scored a mediocre 46.8%. In closing, if we are unable to dissuade you from the folly
of market-timing, then please listen to the advice of two very wise men of the investment world:
"If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market."
- Benjamin Graham, Legendary investor and co-author of the 1934 classic, Security Analysis
"Market Timing is a wicked idea. Don't try it — ever." and "Contrary to their oft articulated goal of outperforming the market averages, investment managers
are not beating the market: The market is beating them." - The Loser's Game, 1975.
- Charles D. Ellis, author of Winning the Loser's Game and The Loser's Game, 1975.
This article was inspired by a question recently received from an IFA.tv viewer. If you have any investment-related questions you want answered, feel free to
send them in to Index Funds Advisors (firstname.lastname@example.org), and we will do our best to answer them.