Sharing Tips on Forecasting

Earlier this week, we all engaged in our bad habits for the last time as our New Year’s resolutions went into effect.

There will be no more smoking, drinking to excess, wasting time, being mean to children and animals, and so forth. We also established new habits of eating better, exercising more, being nicer to everyone, reading the classics and all that other good stuff. Next week, if not this weekend, we’ll be back to the way things were before.

In addition to making resolutions, many people begin the year by establishing expectations for the year. In the financial world, many people establish expectations not only for themselves but also for the economy and markets. If you’re inclined to make forecasts, or want to evaluate the forecasts of others, there are some guidelines to consider. This week I’ll review some of the guidelines I’ve found helpful, and they also are among those recommended in “Superforecasting” by Philip Tetlock.

Begin with the realization that future events aren’t binary. For example, it is not a good practice to try to determine if 2017 will have a bull market or bear market in stocks. There is a wide range of possible returns that aren’t captured in the simple bull-market-or-bear-market choice. Instead, you want to consider what seem to be the most likely outcomes and try to assign a probability to each. Tetlock says good forecasters tend to have 15 or 20 possible outcomes with different levels of uncertainty for each.

It is important to be open-minded. Too many people start with a bias. Some are biased toward either optimism or pessimism. Others are biased by ideology. As Tetlock says, good forecasters “treat their beliefs as testable hypotheses, not sacred possessions.”

A good practice is to always search for the counterarguments to the points you’re making. Too many people search for arguments and facts that support the opinions they’ve developed. Good forecasters look for the counterarguments and carefully evaluate them. Some good forecasters recommend an exercise they call a pre-mortem. You assume that a year from now your forecast was wrong. Then, develop an explanation for how that happened. This exercise helps you find the weak points in your view.

You also need to revise and reconsider forecasts on a regular basis. I hear from a lot of people that they set their portfolios at the start of the year based on what they believe is the most likely outcome, and then don’t expect to change them. The markets and economy provide new information and evidence every day, and you need to evaluate and possibly revise your forecasts in light of the new information. The regular revisions are likely to be small. But over the course of the year, you could end up in a dramatically different place then the initial forecast. Tetlock adds that one of the more common mistakes among poor forecasters is a failure to revise their views. But another mistake is to reverse a forecast based on the latest information. That means a key skill is to strike a balance between overreacting and underreacting to new information.

Finally, you need a process and should adhere to the process. Most people don’t have a process for evaluating things and making decisions. Others have a process, but they abandon it the first time the results aren’t good. No forecaster is right all of the time, and no process will have the right answer every time. But having a good process ensures you’ve considered all the variables and aren’t letting your biases determine decisions.

The Data

Manufacturing appears to be continuing its recovery. The ISM Manufacturing Index rose sharply to 54.7, its highest level in two years. New orders were at a two-year high, and exports orders were at two-and-one-half-year highs.

The PMI Manufacturing Index, which isn’t as broad-based, rose a modest two tenths of a point to 54.3. But that still indicates solid growth, and many components of the index reached highs of one-and-one-half years or longer.

Business in the Chicago area slowed a bit. The Chicago Purchasing Managers Index declined to 54.6 from 57.6. This tends to be a volatile index, so don’t put much weight on one month.

The non-manufacturing sector of the economy continues to do well. The PMI Services Index was down slightly to 53.9. But the two previous months were one-year highs, so the index still shows the service sector is growing at a solid rate.

The ISM Non-Manufacturing Index stayed unchanged at 57.2. This is above expectations, because the consensus was for a slight decline. The index remains at its highest level in more than a year and among the highest levels of the economic recovery.

The data leading to Friday’s Employment Situation reports give mixed indications. The ADP Employment Report showed only 153,000 new private sector jobs for the month. That’s well below last month’s 215,000 and also below expectations. But new unemployment claims declined by 28,000 to a very low 235,000. The holiday period required a lot of estimates, so the number should be treated with caution.

The Markets

Year-end tax selling is over, and stock markets started 2017 with gains. The S&P 500 is up 0.97% for the week ended with Wednesday’s close. The Dow Jones Industrial Average returned 0.54% during that period. The Russell 2000 rose 1.87% for the week. The All-Country World Index rose 1.67%, while emerging market stocks soared 2.91% during the week.

Long-term treasuries continued to recover with a 1.32% gain for the week. Investment-grade bonds rose 0.97%. Treasury Inflation-Protected Securities (TIPS) gained 0.77% and high-yield bonds returned 1.13%.

The dollar gave up some recent gains, declining 0.71%.

Energy-based commodities declined 0.83%. Broader-based commodities lost 0.95% but gold gained 2%.

Bob’s News & Updates

Many people have benefited from my latest book, the revised edition of “The New Rules of Retirement.” Read the many positive reviews on Amazon.com.

I’m getting ready for the MoneyShow Orlando, Feb. 8-11, at the Omni Orlando Resort at ChampionsGate. For free registration, use my priority code, 042315, and mention it when you call 1-800-970-4355 to register.