Thursday, January 11, 2007

Don't take those economic forecasts so seriously

Nice WSJ op-ed today (subscription required), by James Grant, on how economic forecasting is close to meaningless ...
Yet, try as they might, the economists can't seem to get fabulously rich.

It's not for lack of attention to detail. "Up" or "down" isn't good enough for them. They want to tell you what a particular rate will be on a certain date, and they want to give it to you to the second decimal place to the right of zero.

"Yields on two-year notes, the most closely linked to the Fed's benchmark, will fall to 4.49 percent from 4.79 percent as of 7:40 a.m. in New York today . . . ," Bloomberg News reported on the first business day of the new year. "Ten-year note yields will end 2007 at 4.62 percent, down from 4.69 percent today. . . ."

Bloomberg was reporting on a New Year's survey of 22 government bond dealers (so-called primary dealers, because they are licensed to trade with the Federal Reserve). It happens every year. Journalists call up the dealers, and the dealers come to the phone. The journalists know that the dealers don't really know. Nobody could. But the dealers pretend.

The ritual lives on because people crave certainty -- especially where it's inherently unavailable. Many years ago, Lee W. Minton Jr., a Philadelphia bond investor, shook his head over these futile exercises in soothsaying. "The hardest price in capitalism," he said about the particular interest rate over which he was then puzzling (but wisely had no expectation of forecasting).

Predicting the track of interest rates sounds easy enough. Determine the supply of, and demand for, lendable funds. Estimate their rate of change. Fix the point at which they will intersect. That is the future rate of interest.

Of course, there are other small considerations, including the world-wide demand for dollars, the inflation rate, the unemployment rate, the economic growth rate, monetary policy and fiscal policy, not to mention the vagaries of human perception. The phobias and certainties of fixed-income investors are forever changing. A 4% rise in the CPI, for example, is compatible with many different government bond yields. In 1984, a 4% inflation rate provoked a panicked run-up to 14%. People doubted that the CPI would long remain so well behaved -- it had reached double digits in the 1970s -- or that, once it flared anew, Paul A. Volcker, then the Fed chairman, would have the heart to beat it down again. On the other hand, a virtually identical inflation rate in October 2005 was compatible with a bond yield of only 4.5%. People just knew that inflation was dead but that, if, by chance, it wasn't, there was no better man than Alan Greenspan, "the Maestro," to bury it again.

Not everyone puts stock in these errant forecasts. Value investors famously don't. They buy (or don't buy) the security in front of them. What may or may not be coming down in the macroeconomic pike is irrelevant to them. As protection against the kind of accident that always seems to catch Wall Street unawares, they insist on investing at low prices. In the absence of such opportunities, they sit on their wallets. So the question that a disciple of Benjamin Graham would ask about interest rates is not, "Where are they going?" but, rather, "Are they high enough to provide a margin of safety if -- just this once -- everything in the macroeconomy doesn't go exactly according to plan?"

The answer is probably no. Interest rates are low, and the premium of risky rates to government rates is tight. True, long-dated U.S. government bond rates have been much lower than they are today. Since 1870, in fact, they have averaged just 3.5%. But up until 1914, there was no Federal Reserve. In that halcyon time, prices tended to fall in peacetime and rise in wartime (or when new gold discoveries augmented the world's monetary base, as they did after 1900). Since the institution of the Fed, inflation has been the rule, in peace as in war. And since 1971, when the dollar was cut loose from the last frayed hawsers of the gold standard, long-term Treasury yields have averaged 8%, a sizable premium to today's 4.76%.

But, for whatever little it's worth, here's what the DOW Dec 31 2007 "on or above 12500" looks like:

Price for 2007 Year End Dow Jones Industrial Average at

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