Economic Forecasting In A World Of Uncertainty
"The only function of economic forecasting is to make astrology look respectable."
John Kenneth Galbraith
1908 - 2006
The 2020 stock market continues to be a head-scratcher. And though many Wall Streeters claim not to be influenced by short-term fluctuations, most professionals appreciate a different reality. In bull markets, investors worry about outperforming the general market. But when share prices tumble (as they did last spring), carefully orchestrated strategies unravel and investors flock to cash equivalents. Over time, it’s a recipe for portfolio turnover, increased transaction costs and tax liabilities – all performance killers.
The current cycle is no exception. In the face of a worldwide pandemic, a shuttered (but gradually reopening) economy, and political upheaval, it is not surprising that the stock market suffered devastating first quarter losses. But it would have been a mistake to have bailed out then. All the major indexes rebounded to close the third quarter within a smidgen of their all-time highs. Through September, the S&P 500 had gained 4.1% thus far into 2020 and the technology-laden Nasdaq rose a whopping 24.5%, while the Dow Jones Industrial Average was still 2.7% below its December 2019 close. So, with all the well-documented challenges facing the global economy, was this rapid market recovery rational? Let’s take a closer look.
Start by recalling that a year ago the consensus economic forecast called for 2% growth in 2020 US Gross Domestic Product (GDP). But when the coronavirus hit, GDP declined by 5% in the first quarter, followed by a 31.7% drubbing in the second (Figure 2).1 As a result, this year’s estimate was revised to -4.0%, potentially the worst calendar-year performance since 1946. Yet the bulls marched on.2
What’s the plausible explanation? Simply put, the stock market isn’t the economy. Boiled down, it’s the price of the economy – a distinct time series. Plus, though linked, share prices are forward-looking while GDP statistics are after-the-fact tallies. Small wonder statistical testing confirms that financial asset pricing can provide an indication as to which way the economy is likely headed.3 And as GDP goes, so go corporate profits, dividends and so on, hence the recent rise in share prices. On this score, next year’s economy is expected to resume an upward trajectory (Figure 3).
Still, the outlook is problematic. After all, there’s no way to quantify the pandemic’s likely impact. That said, an important perspective emerges by simply observing competing forecasts and deriving an average forecast. As shown below, there’s a general expectation that the 2021 GDP will prove supernormal, especially if a Covid vaccine materializes.
Finally, keep in mind that statistics can be misleading. Should the average consensus outlook pan out, the economy will have simply returned to near-2019 levels – something market participants seemed to have already discounted.
While no one can accurately predict the future, the rapid market recovery is supported by an expected improvement in economic fundamentals.
1 According to the National Bureau of Economic Research, the US economy officially entered recession territory last February.
2 See “The Coronavirus Head Fake,” Boston Research and Management (July 22, 2020).
3 As a technical matter, roughly half of the annual change in GDP is explained by prior-year changes in financial asset price movements.