Why recessions are tough to forecast?

Mon, 6 May Pre-Open

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Forecasting something as big as a recession is not the easiest task. With finance professionals finding it difficult to predict the same, it would have been nearly impossible for non-finance professionals to have done so. Despite knowing the fact that the analyst community missed the call on what was one of the biggest financial calamities in the last century, it would not be entirely wrong to say that people still wait for their predictions and forecasts. Be it broader parameters such as inflation or GDP growth or specific parameters such as earnings and stock prices.

Moneylife stated about a fortnight ago, 'the main problem is the future. No one can predict it.' And despite knowing that forecasters do not get their calls right time and again, people are still addicted to hear what they have to say. Given that the world has been moving along a steady pace over the long run (and not the recent past), a general consensus is that major companies would chug along, growing at decent and steady paces. This would eventually lead to steady growth in earnings, leading analysts to have an optimism bias for almost all companies!

As reported - 'One of the most interesting and consistent issues with analyst forecasts is optimism. Forecasts for earnings growth are always sunnier in January. Forecasts for the American market index, the S&P 500, at the beginning of the year predict rising profits. For the past 26 years, both European and American analysts have predicted increased earnings although they have fallen one-third of the time.'

Profit forecasts not only predict positive earnings, their annual forecasts start out higher than they end up. Over the two-and-a-half decade period, there were only three years (1988, 2005 and 2006) when forecasts ended up more positive, than at the end of the year.

Not only is the bias wrong, but often the accuracy is way off. European forecasts were off by 20% a third of the time. The US was a bit more accurate, but nothing to be proud of. American analysts were off by more than 10% half the time.'

Moneylife's article also discussed the vested interests that analysts and managements have in showing rosy pictures, or in not disclosing the truths. But that's a story for some other day.

While incidents such as recession, slowdowns, and bankruptcies may not be the easiest to predict, one would probably factor these in by lowering the long term growth rates. But, rarely would one find analysts lowering earnings.

There's only one thing that you can do...

For investors, it would only make sense to do their own homework and escape all the noise that goes around. There are no two ways on how to go about getting a basic understanding of companies and industries from various sectors, the segments the operate in, the reason for earning different margins from peers, whether high margins are sustainable, the health of the balance sheets, the long term growth rates, etc. These are just some of the many questions that investors must pursue. Company annual reports are good starting points.

Also, one could shield himself from the 'biased' forecasts and predictions by buying stocks - after having studied them thoroughly - at attractive valuations. This is where the concept of margin of safety steps in. Buying a good company at a bargain price would in all probability benefit investors, especially during times of uncertainty and difficulty.