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Forecasting the future | Unravelling the mysteries of market predictions and the lessons of 2008

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By Capital Partners Markets and Investments

“Prediction is very difficult, especially if it is about the future.”

So said the Danish physicist Niels Bohr, whose ground-breaking work in quantum mechanics and atomic structure earned him a Nobel Prize in 1922.

The truth contained in Bohr’s cheeky observation is highlighted every year in the prognostications of market economists – but no more so than in 2008.

To be sure, this was an extraordinary year – one in which market capitalism was shaken to the core, vast swathes of the investment banking industry ceased to exist and governments and central banks globally instituted unprecedented policy action to restore stability.

While red-faced about their ropier forecasts, economists defend themselves by saying no-one could have foreseen these events – to which the obvious reply is to refer them back to Bohr’s quote above.

Just how badly economists got it wrong is made evident by a review of a survey of Australian forecasts, published in early 2008 by The Sydney Morning Herald and The Age of Melbourne.

These broadsheet publications, considered at the quality end of the media spectrum, promoted the half-yearly survey as “one of the longest-running and most comprehensive collection of forecasts in Australia”.

The newspapers canvassed the opinions of “28 leading economists from the finance sector, business and academia” on such issues as currencies, interest rates, the share market and economic growth.

Broadly, the consensus of the esteemed panel was that 2008 would be a year of solid share market gains, lower unemployment, persistent inflation and upward pressure on interest rates. (That’s zero out of four so far.)

Looking at forecasts for individual variables, the best you can say is that some of the panel got it less wrong than the others. But the bottom line is that everybody got it wrong.

Take the Australian dollar for instance. You might think that after the experiences of early this decade – when the $A wrong-footed every forecaster to plumb unheard-of depths below 50 US cents – that people would have given up the pretence that there is any science to forecasting currencies.

But no. Like blindfolded five-year-olds high on red cordial at a birthday party, they are still trying to pin the proverbial tail on the foreign exchange donkey. In the Herald/Age survey, the consensus for the $A by the end of 2008 was 90 US cents, with individual predictions ranging from a low of 77 to a high of 95 cents.

As it turned out, the upper end of this range was busted by as soon as May, while the lower end was penetrated in early October when the $A plummeted by 6 US cents in the space of a single day.

In its most tumultuous year since being floated in the mid-1980s, the Australian dollar got to within a whisker of parity at 98.49 US cents on July 15. Then, true to its reputation for taking the stairs up and the elevator down, it slid all the way back to just above 60 US cents on October 28. It finally ended the year just above 70 US cents, a decline of nearly 20 per cent over 12 months.

How can anyone forecast this sort of crazy price action? More importantly, given the very low probability of being proven correct, why would anyone want to risk their reputation by doing so?

Anyway, it should be evident that if the economists got their currency forecasts so wrong, their projections for interest rates wouldn’t be far behind.

Sure enough, of the sample of 28 economists, just over half expected a further one or two-quarter percentage point increase in the Australian benchmark official cash rate in 2008. The next biggest group saw rates as staying on hold, while a minority of three expected rates would be lower.

Looking back now, the Reserve Bank did increase the cash rate twice more – in February and March, the last in a prolonged series of monetary policy tightenings that extended all the way back to mid-2002.

But then, from September, it instituted a dramatic reversal, totally unwinding that six-year tightening cycle in just four months, including two moves of a full percentage point. The reversal took the cash rate down by a total 3 percentage points to a 7-year low of 4.25 per cent.3 No-one foresaw this.

As for the share market, it would be fair to say that the 2008 forecasts of our star panel would not be included in a collection of their greatest hits.

The consensus prediction was an 8.1 per cent increase in the Australian benchmark S&P/ASX-200 index over the course of the year to 6856. Individual forecasts extended down from the most optimistic of 7650 (a rise of 20 per cent) to the most pessimistic of 4500 (a fall of 30 per cent).

As it turned out, even the gloomiest guru was whistling Dixie. We now know that the Australian market suffered its worst-ever year in 2008. The S&P/ASX-200 slumped by 41 per cent to 3722.3, having reached a trough of 3352 on November 20, its lowest point in more than four years.

To be sure, participants in these surveys caution that their projections are not forecasts, so much as assumptions. And many concede that there is little science in forecasting the variables, particularly exchange rates.

But it’s worth asking that if there is such a dismal record of accuracy among the top economic minds about the path of the economy and financial markets, what chance has the retail investor of getting it right?

The fact is no-one really knows.

The good news is that there is a place where all these individual forecasts and possible outcomes – from the gloomiest to the rosiest – combine to give all investors a “best guess” about what might happen next.

It’s called the market.

The information provided on this site is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different and you should seek advice from a financial planner who can consider if these strategies and products are right for you.

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