About Forecasting

The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one.  The commonest kind of trouble is that it is nearly reasonable, but not quite.  Life is not an illogicality; yet it is a trap for logicians.  It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.

—G. K. Chesterton

Two sets of investment recommendations landed in my e-mail box this week: a report called the Research Investment Committee Report (RIC) from a brokerage firm where I have some cash in a money market fund, and the monthly Elliott Wave Financial Forecast (EWFF). It is not possible to have two more contrasting points of view.

The broker says: “We believe global equities (stocks) will provide the best returns over the next twelve months. As a result, we have updated the RIC’s core asset allocation to be overweight equities (stocks) and corporate bonds and underweight government bonds and cash.”

EWFF says, “…the long term outlook for the market is as strongly bearish as it was in early 2000 and late 2007… Hold cash.”

What to do? For starters, let us look at how these analysts arrive at their forecasts:

The RIC report’s recommendations are based on the expectation that the Fiscal Cliff will be resolved, Spain will get money from the European Central Bank, and the global economy will grow at the rate of 3.2%. Why 3.2%? I read the 25 page report carefully. They do not say why they forecast 3.2%.

But never mind-there is no way to forecast future economic growth. It is pure guesswork. Best Buy has no idea how many iPhones they will sell next year. They take a guess, stock the stores, and hope to sell out.

Investing based on naïve guesses is a losing proposition. You don’t know if you guessed right until after the fact. Conventional economics is known as the dismal science because forecasts by conventional economists are usually wrong. Their high error rate is due to their tendency, in the absence of any real methodology, to extrapolate the current situation out in time. The economy has improved, so it will improve. At precisely 3.2%, mind you! Oh, brother.

The EWFF report looks first at the pattern and the action in the market. Is it impulsive or corrective? The last upward impulse wave topped in 2000. Everything since then has either been a downward impulse wave or a counter trend upward corrective wave. This study alone is the reason EWFF has recommended investors be out of the market and in cash for the last twelve years. To date, cash has outperformed the market by a comfortable margin.

Sentiment, momentum, and valuation measures flesh out the basic study to provide confirming evidence of the pattern. In March 2009, the first impulse wave down appeared to be coming to a close, so EWFF’s recommendation to intermediate term traders was to close out shorts and take long positions. Investors were told to stay in cash because the market was still overvalued and retracements have as much potential to end quickly as to extend.

On three occasions over the next three years, EWFF recommended short positions for traders. The first two were early, and the positions were stopped out with modest losses. The third short sale is still on, with a protective stop that has been moved down to breakeven now. Investors continue to be in cash.

The current recommendation, like all the others, is based on what is implied by the market’s present pattern. The forecasts are made organically, with monthly updates reporting on the pattern as it develops. Today, the pattern strongly suggests that the corrective wave ended in October, and the next serious decline is in its early stages. This conclusion is supported by investor sentiment, which is as bullish as it was at the orthodox top in 2000, and at the top of the last big counter trend rally in 2007.

The method used by the analysts at Elliott Wave International yields probabilistic forecasts. Traders and investors are provided with points at which to place stop losses against a wrong forecast. I have relied on their work for many years, and I see no reason not to continue.

Cheers,

Rod

No one should consider any part of this presentation as a recommendation to buy or sell any securities whatsoever.

 

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