Analysts (In)Accuracy Forecasts

I simply can’t understand why so many guys spend so much time engaged in forecasts. They are always too optimistic and with so little chance of success. In short, it's completely nonsense.

Here is what James Montier says about this:

Let’s say you invest according to the following process: forecast the economy, forecast the path of interest rates, forecast sectors which will do well in that environment, and finally forecast which stocks will do well in that sector. Let’s assume you are right on each forecast 70% of the time (massively above the rates actually seen). However, if you require all four forecasts to be correct, you have just a 24% chance of getting it right! (This assumes each forecast is an independent event).

Now think about the number of forecasts an average analyst model contains. Sales, costs, taxes, etc. No wonder these guys are never right. In addition, even if by some miracle your forecast turns out to be correct, you can make money from it if (and only if) it is different from the consensus. This adds a new dimension of complexity to the problem.

The evidence on the folly of forecasting is overwhelming. Economists haven’t a clue. The three blind mice have more credibility than any macro-forecaster at seeing what is coming. The analysts are no better. My colleague, Rui Antunes, has examined the accuracy of analysts. In the US, the average 24-month forecast error is 93%, and the average 12-month forecast error is 47% over the period 2001-06. The data for Europe are no less disconcerting. The average 24-month forecast error is 95%, and the average 12- month forecast error is 43%.

Analysts don’t have a clue about future earnings. Their performance in divining the longer- term future is no better than their performance in the short term. Even a cursory glance reveals … analysts have no idea about forecasting long-term growth.

Why do analysts persist in trying to forecast prices? As Ben Graham said, forecasting security prices is not properly a part of security analysis. Analysts have an embarrassing record with respect to target prices.

In a nine-year study of analysts’ prediction of prices 12 months ahead he found that on average they predicted stocks to be 25% higher each year. I then contrasted this implied analyst view with the actual returns achieved across the same universe, and in four out of the nine years, analysts have not even managed to get the direction of change in prices correct!

The bottom line from this whistle-stop tour of the failure of forecasting, is that it would be sheer madness to base an investment process around our seriously flawed ability to divine the future. We would all be better off if we took Keynes’s suggested response when asked about the future, which was: ‘We simply do not know.’