Can you benefit from forecasts and extrapolations?

We have two classes of forecasters: 

• Those who don’t know – and 
• those who don’t know they don’t know.

Many believe that the future is unknowable.

Some favorite quotes on this subject. (The first one may be the greatest ever):

No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.
Ian E. Wilson (former Chairman of GE)

Those who have knowledge don’t predict; those who predict don’t have knowledge.
Lao Tzu

People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.
George Orwell

Forecasts create the mirage that the future is knowable.
Peter Bernstein

I never think of the future – it comes soon enough.
Albert Einstein

The future you shall know when it has come; before then forget it.
Aeschylus

Forecasts usually tell us more of the forecaster than of the future.
Warren Buffett



There actually are things we know about the macro future. 

However, this is an extreme oversimplification and not entirely correct. There actually are things we know about the macro future. The trouble is that, mostly, they’re things everyone knows. 

Examples include

• the fact that U.S. GDP grows about 2% per year on average; 
• heating oil consumption increases in winter; and 
• a great deal of shopping is moving on-line. 

But since everyone knows these things, they’re unlikely to be much help in the pursuit of above average returns. 

The things most people expect to happen – consensus forecasts – are by definition incorporated into asset prices at any point in time. 




Most forecasts – and especially macro forecasts – are extrapolations of recent trends and current levels.

Since the future is usually a lot like the past, most forecasts – and especially macro forecasts – are
extrapolations of recent trends and current levels, and they’re built into prices.

Since extrapolation is appropriate most of the time, most people’s forecasts are roughly correct.

But because they’re already reflected in security prices, most extrapolations aren’t a source of above average returns.




The forecasts that produce great profits.

The forecasts that produce great profits are the ones that presciently foresee radical deviations from the past. 

But that kind of forecast is, first, very hard to make and, second, rarely right. 

Thus most forecasts of deviation from trend also aren’t a source of above average returns.




Summary

So let me recap:
(a) only correct forecasts of a very different future are valuable,
(b) it’s hard to make forecasts like that,
(c) such unconventional predictions are rarely right, 
(d) thus it’s hard to be an above average forecaster, and
(e) it’s only above average forecasts that lead to above average returns.



So there’s a conundrum:

• Investing is the art of positioning capital so as to profit from future developments.
• Most professional investors strive for above average returns (i.e., they want to beat the market and earn their fees).
• However, according to the above logic, macro forecasts shouldn’t be expected to lead to above average returns.
• Yet very few people are content to invest while practicing agnosticism with regard to the macro future. They may on some level understand the difficulty entailed in forecasting, but their reluctance to admit their ignorance of the future (especially to themselves) usually overcomes that understanding with ease.
• And so they keep trying to predict future events – and the investment industry produces a large volume of forecasts.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

Charlie Munger - Projections do more harm than good

Reading Tea Leaves

" I have no use whatsoever for projections or forecasts.  They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be.  We never look at projections but we care very much about, and look very deeply, at track records.  If a company has a lousy track record but a very bright future, we will miss the opportunity,"  explained Warren Buffett.

Charlie Munger, added that in his opinion projections do more harm than good.  "They are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious.  They remind me of Mark Twain's saying, 'A mine is a hole in the ground owned by a liar.'  Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself."

Here is how Graham and Dodd looked at projections.  "While a trend shown in the past is a fact, a 'future trend' is only an assumption.  The past, or even careful projections, can be seen as only a 'rough index' to the future."

More than five decades have passed since those words were said, and Buffett still agrees.

Earnings Season Investor Importance

If you are a buy and hold investor then you should not be very concerned about the earnings season since its focus is on short-term goals. Earnings season affects the prices over the short term. So, it is important to active traders who may seize different opportunities.

http://www.stock-market-investors.com/stock-investing-basics/earnings-season-basics.html

The biggest assumption and risk for investors: Earning Forecast

The biggest assumption in any valuation model is the earning forecast.

We have assumed that the earning forecasts by various analysts are good and accurate. This is the biggest risk investors have to face.

In general, investors can use consensus earning forecasts for computing the valuation, however, through experience, investors can identify good analysts from not so good ones, and hence, can be selective in using the earning forecast data.

Bear in mind that a way-off-earning forecast (especially over-bullish) could have disastrous effects on the stock price once the actual result is announced.

A good practice is to compare the forecast EPS growth rate with the averge EPS growth rate in the past three years and see whether the forecast EPS growth rate is in line with the historical numbers.

In short, what investors are looking for is an accurate EPS growth forecast.