Known Knowns and Known Unknowns in economic and equity research

Neel Kashakari of PIMCO is just too optimistic on known knowns in economic research this interesting essay.

He begins his article saying people love bold predictions with some coming right and some falling flat.

People love bold predictions. More precisely: People love people who make bold predictions that are eventually proven correct. We tend to put such soothsayers on pedestals and anoint them heroes. And why shouldn’t we? They were able to see important outcomes that the rest of us missed.
Consider two notable examples:
  • In 1969 quarterback Joe Namath boldly guaranteed his underdog New York Jets would beat the Baltimore Colts to win the Super Bowl. An audacious prediction, when Namath successfully led his team to beat the Colts he ensured his place in sports history.
  • In 1961 President Kennedy called for the nation to land a man on the moon and return him safely to Earth by the end of the decade. At the time an American hadn’t even orbited the Earth, let alone made it to the moon. Considering today it takes almost a decade just to design a new rocket, Kennedy’s call to action from virtually a blank sheet of paper was truly a “moon shot.”
But our memories tend to be skewed: we remember the heroes but often forget the bold predictions that fell flat. For example:
  • What was the name of the pastor who predicted the world would end on May 21, 2011? I can’t remember either. I’m sure I would remember had the world actually ended. (Well, maybe not, but you get my point.)
  • In December 2007 sell-side equity strategist Abby Joseph Cohen predicted the S&P 500 would climb from 1,463 to reach 1,675 by the end of 2008. Given the brewing financial crisis, this was a bold call. In fact, the crisis dramatically worsened and the S&P 500 ended 2008 at 903. As the U.S. crisis recedes into memory, people have moved on.

Why is this so? We have both Known Knowns and Known Unknowns in predictions. The ones which follow the first mostly come out to be true:

 

I believe two questions are essential to assessing predictions:
First, is the prediction “knowable?” Joe Namath was certainly able to influence the outcome of the Super Bowl. His prediction should have carried more weight than that of the average football commentator. We should pay more attention to those with special insights into knowable topics.
Second, does the person making the prediction have any downside if wrong? While President Kennedy is rightly lauded for setting the country on a path that transformed America’s standing in the world, presidents frequently make such bold calls, and the majority of them expire unfulfilled and unnoticed. For example, in 1983 President Reagan called for development of a missile shield to defend America against a nuclear attack from the Soviet Union; “Star Wars” never came to pass. In 2003 President Bush called for hydrogen cars to be commercially viable by 2020; seven years later President Obama cancelled their funding. There is little downside to Presidents setting ambitious goals – and they might improve their place in history if one of them works out.
In a society where we hoist the heroes but forget the mistakes, incentives are strongly skewed toward making as many bold predictions as possible, because at least a few are bound to hit. We should pay more attention to those who actually have something to lose if they are wrong.
Based on this, we can forecast known knowns in economic and financial markets:
Known Knowns: 
  • Global economic outlook. 
  • Relative value among asset classes. 
  • Outlook for an individual security, be it a stock or bond. 
Known Unknowns: 
  • The level of the stock market on a particular date in the future. 
I don’t think we can put the 3 known knowns as that simply forecasteable. They are pretty much unknown as well. We go wrong on them all the time.
Anyways, he ends by saying we need to know who is making the forecast. The guy on the buy side always has a stake and usually doesnt give these bold unknowable forecasts. The one on the sell side who is influencing fund manager decisions and has nothing at stake makes these unknown predictions:
Most of the commentators predicting the level of the Dow at year-end are sell-side analysts rather than investment managers. This makes sense: There is little downside for being wrong most of the time. The interesting question for the investment managers who do partake in such fortune-telling is do they actually utilize their own predictions? Most equity investment managers are managing portfolios that are required to be fully invested in equities at all times. If they believe the Dow will close at 13,000 on December 31, can they actually take advantage of that view since they don’t have idle cash to put to work? And if they can’t use their own predictions, why are they making them in the first place?

If we’re right – and neither PIMCO, nor anyone else, can accurately predict the level of the stock market at a certain date in one week, one month or one year – why do so many sell-side analysts (and a few investment managers) make such predictions? And why do we pay any attention?

I understand the flavor of this piece but don’t buy it. Any forecasting is unknown and we just try and make it known or give it some probability  of it happening. A forecast of tomorrow might be better placed compared to  say 3 months and 1 year down the line. So the more the time of the forecast, the worse you are placed and that is the forecast people expect from you.
Kashkari says Global economic outlook is a known known. Really? The closer we move to the time period the more you realise how your outlook was wrong. So say you forecast something in Jan for Dec the closer you come to Dec you start revising your forecast. You may have all the data and analysis in the world, but forecasting is always tough.
As Bernnake rightly said in a speech, the only thing I know about my forecast is it is unlikely to happen. It is a big known unknown.  We still give it to guide expectations and help understand some emerging scenario. There is nothing more to it then that..

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