It was a tough year for economists. Granted, no one could have predicted the turn of events that led to one of the deepest recessions in our history. However, as both the economy and stock market were regaining their footing last Spring, it seemed that economists were still tripping over themselves trying to make some sense of it all. For example, economists predicted that the unemployment rate would hit 20 percent—or close to it—in May. When it came in at 13.3 percent, which was an improvement from 14.7 percent in April, even an economist had to admit “it was the biggest forecast miss of our life.”
But it didn’t end there. Using an economic model that incorporates economic risk factors and market risk factors, the model produces a monthly forecast based on stoplight colors—red light, yellow light, and green light. Beginning with the market and economic bottom last March, the indicator flashed a red light, implying “danger ahead.” The red light continued to flash each month from then on through December. Meanwhile, the Russell 3000 index gained an astonishing 44 percent in that same timeframe. It brings to mind a Warren Buffett quote, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”
| Economic Risk | Market Risk | Russell 3000 Index | |
| April 10, 2020 | Red | Red | 1489 |
| May 12, 2020 | Red | Red | 1684 |
| June 9, 2020 | Red | Red | 1771 |
| July 14, 2020 | Red
Red |
Red
Red |
1809
1909 |
| Aug 12, 2020 | |||
| Sep 8, 2020 | Red | Red | 2045 |
| Oct 6, 2020 | Red | Red | 1968 |
| Nov 17, 2020 | Red | Red | 1923 |
| Now | 2148 | ||
| Total | Return | 44.30% |
Why Economists Get It Wrong
First, let me say that I respect the profession of economics. I have a B.A. degree in finance with a minor in economics. Economics was my first love in my academic career, and I still follow it closely as it pertains to understanding public policy and corporate planning. However, history has shown us that, while economists are very good at explaining what happened in the past and moderately good at explaining what’s happening now, they are terrible at predicting the future. For that reason, investors need to be wary of factoring in economic analysis and prognostications into their market outlook.
Economists rely on multi-factor models to crunch current data and spew out a relatively simplistic bottom-line analysis. They also make assumptions based on how they believe consumers and companies will behave under certain circumstances. In reality, people and businesses don’t behave in the collective as expected. Instead, they act individually, making millions of individual decisions which may or may not comport with the economists’ assumptions.
What the Stock Market Knows That Economists Don’t
The millions of participants acting individually in the economy make it difficult to forecast economic activity. However, the millions of participants acting individually in the stock market is the precise reason why the stock market is a much better forecaster of future economic conditions. Whereas economists rely on current data to forecast, the stock market, with its millions of participants, is constantly adjusting in anticipation of changes in the economy six to 12 months from now. Investors are continually assessing current data and analyses that forecast future asset valuations. The market is a discounting mechanism that digests all available information in real-time and discounts future asset values to their present value, which determines current stock prices.
Last year while economists were flashing red over current unemployment numbers, the stock market was looking past the pandemic to the other side of a V- or U-shaped economy and the earnings growth it will produce. While economists were wallowing in the economic numbers of a deep recession, investors were anticipating fiscal and monetary policy intervention, which, historically, has improved the economy. When economists were busy forecasting doom, investors had faith that the government, in concert with private industry, would be successful in producing a vaccine.
The stock market doesn’t care about today’s headlines as much as it cares whether things are getting better or worse. From the depths of the last recession, the market was looking to better employment numbers and the race to develop a vaccine that would eventually reopen the economy.
The Bottom Line: Invest in What You Know
On a more micro level, investors who know precisely how to allocate their capital among businesses they know extremely well tend to fare better than the rest of the market, especially during difficult times. For example, based on extensive due diligence and analysis, we know that our portfolio of companies are better positioned than most to weather severe storms. While it’s not a simplistic process, it’s much easier than having to figure out an entire economy.
While many industries and companies were suffering last year, our portfolio of companies grew their earnings per share by 18 percent on average. Some grew much faster, while some grew slower. Some even experienced a drop in earnings. The critical takeaway is if you know the businesses you own and what they’re doing to make money, and you’re managing a portfolio collectively, you don’t have to fall victim to the whims of an unpredictable economy.
