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January 1, 2010

EVERYONE IS A FORECASTER

Why Every Company Needs to Develop its Own Forecasting Habit

Business publications are filled with all kinds of forecasts. You can spend all day every day reading the best guesses of “experts” on the economic outlook, market trends, Fed policies or government spending. You can prepare your company for a range of conditions based on the estimates of hundreds of public and private prognosticators. And then you can watch the bottom fall out when an economic crisis hits swiftly and deeply, as did with our Great Recession of 2007-2009.

What surprised me was not that the Great Recession happened—my own forecasting method predicted it months in advance. What surprised me was how many business executives were caught by surprise given the numerous warning signals.

The metals industry was especially shaken by it. A common comment beginning in the fourth quarter of 2008 was, “It was like someone simply turned the switch to ‘off.’” Because of the failure of so many metals industry executives to anticipate the Great Recession, the losses were substantial.

If your company was among the many that missed the signs of the Great Recession, it may be time for your executive team to broaden its job description to that of “economic forecaster.” In this regard, because economic risks have so much more impact on a company’s future than the usual strategic risk, I believe that every business executive and money manager must learn to be an economic forecaster.

I know that most businesspeople believe accurate economic forecasts are something of a black art. After all, why else do economists study and train for all those years to learn their craft? But here’s the truth about economic forecasting: Any competent businessperson can do it well enough to help safeguard his or her company’s future. All it takes is a little help to get started, and a habit of regularly checking 11 economic indicators and reports, all of them routinely updated and readily available.

To show you the power of my Always a Winner forecasting method, let me show you how you could have known that a recession was on the way in 2007 with just three simple indicators. The first indicator was the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index. It began a downward trend in July 2007. The recession officially began in the fourth quarter of 2007.

Next is the Standard & Poor’s 500 stock index. There is a strong relationship between that index and the nation’s economic health. The S&P 500 began to dip strongly in October 2007 and kept right on going down.

Indicator No. 3 is the “yield curve spread”, which measures the spread between the yields on the 90-day Treasury bill and the 10-year bond. In fact, an inverted yield curve spread has successfully predicted the last four recessions—where an inverted spread occurs when short-term yields are higher than long term yields.

In the case of the Great Recession, interest rates paid on short-term government debt rose above those for long-term debt as early as August 2006. This negative spread provided the earliest warning of a possible recession of all of the major indicators.

If just one of these three major indicators signaled recession—the ECRI index, the stock market, and the yield curve spread—you could be excused for thinking the evidence of impending recession wasn’t strong. But all three? The broader point is that executives who were watching the economic landscape had definite clues about what was coming.

Let’s consider now in a bit more detail what it takes to be your own forecaster. I said earlier that there are 11 indicators and reports that, taken together, will tell you what you need to know. The Always a Winner model for this is built on the five broad components of gross domestic product, or GDP, and the formula for forecasting looks like this:

GDP = C + I + (X – M) + G

The three indicators we have already discussed help follow the left-hand GDP side of the formula. They are the ECRI leading index, the stock market trend and the yield curve spread.

On the right side of the equation, the indicators are, for C, consumer confidence, retail sales and new home sales; for I, the Institute for Supply Management’s index; for X – M, the eXport and iMport figures from the monthly trade reports; and G is the regular Treasury Department update on the federal government’s budget.

One other factor to consider is inflation, which you track with the consumer price index and the producer price index. Inflation is important because if it starts to rise, the Federal Reserve may hike interest rates and choke off an economic recovery.

So that’s the universe of reports necessary to track the economy and forecast, for yourself, the outlook. It’s not foolproof, but this model covers all of the major economic factors and formulas that, taken together, can help you avoid going wrong. I describe how to use these factors in an article on the Moody’s Economy website, The Dismal Scientist. Moody’s provides a free trial of the site, which is the single best site you can use to keep track of these indicators and more, if you like. I encourage you to download a copy of the article and begin learning how these pieces interact for yourself. Once you grow even a little comfortable with the pieces, your sense of where the economy is going will improve. As it does, your chance of avoiding the mistakes of this recession in the next one will improve, too.


Peter Navarro, a business professor at the University of California, Irvine’s Merage School of Business, is a well-known speaker and widely published author whose most recent book, Always a Winner: Finding Your Competitive Advantage in an Up and Down Economy, was published in 2009 by John Wiley & Sons.