11/30/13

How clouded is our financial forecasting? - Economic Times

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You are here: Home > Collections > Market Participants

How clouded is our financial forecasting?

Sep 30, 2013, 04.00AM IST

Tags: RBI

PMEAC

Inflation

gdp

Equity

Economic forecasting

Economic Advisory C ouncil

By Anand Tandon

Of late, equity markets have behaved as thought it has a multiple personality disorder euphorically up one day, manically depressed the next. Much of this is attributed to market-moving policy pronouncements. Equally, volatility arises when key economic numbers are released. Talking heads on TV often attribute market movements to differences between forecast economic numbers (in particular GDP growth and inflation) and the "actual". But are the forecast figures useful for market participants? What makes a good forecast?

(How clouded is our financial)

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An obvious requirement for a good forecast is "accuracy" how good was the forecast compared with the actual outcome? Since the "event" is yet to occur, another consideration is if the forecast is "honest". In other words, was it the best prediction the forecaster could make, or was it deliberately coloured or biased? A third factor could be the "value" of the forecast did it convey information that was useful in making decisions? Understanding Predictions When dealing with the future, we deal with probabilities. In making a forecast, the forecaster deals with multiple scenarios and, either explicitly or implicitly, assigns a probability to each scenario. A "point forecast" a weighted average of future expectations is, usually, less useful. A wide distribution of possible outcomes best represents the uncertainty inherent in the real world. Our minds, however, tend to regard probability-based forecasts as somehow not so satisfying as if the forecaster is hedging his bets. Professional Predictors Starting 2007, the Reserve Bank of India conducts a survey of professional economists. Those surveyed offer forecasts for a number of macroeconomic variables. These forecasts are made every quarter, and the RBI publishes the results on its website. Among other variables, the professional forecasters offer their estimates for GDP growth, its key components and inflation. The forecasts for GDP are made in the form of a probability table. The RBI combines the forecasts to yield a minimum and maximum forecast range, as well as the median. The picture summarises GDP growth forecasts made in April-May for the next 12 months since the survey started. A quick glance reveals that forecasters do not cover themselves in glory In each of the five years where data is available, the actual GDP growth is outside the minimum-maximum range forecast. Take a minute to digest that. It is not just different from the median, it is outside the forecast range and often by a wide margin.

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11/30/13

How clouded is our financial forecasting? - Economic Times

Govt's Forecasters The prime minister's economic advisory council ( PMEAC) too makes estimates for the same figures twice a year. Unfortunately, it offers a "point estimate" instead of a range. While this gives the perception of being more decisive and accurate, as the table shows, their track record is equally poor with some estimates having an error of over 10% from the actual when made only 30 days before the end of the financial year! The one redeeming feature is that forecast directions seem to be correct: each subsequent forecast moving in the direction of the eventual number. Poor Numbers Economic forecasting is important in that policies are adjusted to move the economy in the desired direction. What causes these forecasts to be poor? Assuming that forecasters are not wholly incompetent, errors can arise out of three possible factors:

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(a) Data used to make forecasts is of poor quality. Remember, revisions to the final GDP growth continue for almost two years and advance estimates are notoriously poor. This calls in question the importance attached to near-term data. When RBI/government says it formulates policy on the basis of data, it's fair to ask: What data? (b) Forecasts are biased. This is also a real possibility. Median forecasts tend to cluster around 6-8% growth. Forecasts are understated in years of high growth and overestimated in those of poor growth. There is a visible tendency to cluster around the "centre". It seems no one wants to rock the boat. But then, this "conservatism" also reduces the value of forecast in policy formulation. (c) Models are poor. An economy is a dynamic system feeding on itself and other external stimuli. Models attempting to replicate economic performance have to factor in a large number of inputs. Additionally, models are likely to be susceptible to "initial conditions" which themselves may be sources of errors.

In all the cases, the important point that the investor needs to note is that market volatility caused by data releases is largely unwarranted. It provides the patient investor an opportunity to make abnormal gains by betting against short-term moves. It is important to remember that the apparent accuracy of most economic numbers is a mirage and the best one can use them for is to determine the direction of the trend. The writer is CEO of a financial firm.

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How clouded is our financial forecasting? - Economic Times

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Readers' opinions (4)

Sort by: Newest | Oldest Kasi Iyer Sheeravarneswaran Kasinathan (chennai) 01 Oct, 2013 01:27 AM It is similar to our erstwhile weather forecast,may or may not rain PAWAN KUMAR (FARIDABAD) 01 Oct, 2013 01:23 AM Speak of big thing and doing nothing HiteshSrivastav Srivastav (Mumbai) 30 Sep, 2013 07:00 PM Small time investors are suffering more in current scenario...they should keep patience in this time. Trader (India) 30 Sep, 2013 06:07 PM The traders are suffering from Dhirubhai Ambani sydrome. He had multiple pre-determined balance sheets ready. He released them based on his whim. There is no system here. Its just a Whimsical culture.

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