By Bob Willis
Oct. 23 (Bloomberg) -- Joel Naroff was visiting Arizona in September 2005 when he had an epiphany. Phoenix-area realtors were looking for home prices in the metropolitan area to surge about 40 percent for a second year.
``That was an indication to me that the market had gotten out of control,'' he recalls.
Naroff's concern about a housing bubble paid off three years later: He's the top forecaster of the U.S. economy in a period that included the start of the global credit crisis, according to data compiled by Bloomberg. Naroff, 59, was the most accurate for his combined predictions for gross domestic product, unemployment, the consumer price index and the Federal Reserve's benchmark interest rate.
The survey covered 10 quarters starting in January 2006 and ending in June '08. During that time, homebuilding plunged, subprime-mortgage defaults infected banks and the Fed cut rates at the fastest pace in two decades. Since then, banks have failed, President George W. Bush has signed a $700 billion rescue bill and the Standard & Poor's 500 Index was poised for its poorest annual performance since 1937 as frozen credit markets threatened the worst worldwide recession in a quarter century.
Stock markets rallied on Oct. 13 after the U.S. government agreed to buy stakes in banks and the Fed led a push to flood the global financial system with dollars. As of Oct. 22, the S&P 500 had tumbled 39 percent this year.
``It's a world we've never seen before,'' Naroff says.
Far From Chaos
Unlike most of the 126 forecasters Bloomberg rated, Naroff makes his predictions far from the chaos gripping Wall Street. He's the self-employed president of Naroff Economic Advisors, working at home either in the Philadelphia suburb of Holland, Pennsylvania, or at his New Jersey shore vacation house.
``I walk or I go outside,'' he says. ``That's how I do my thinking, by moving or by being active.''
Naroff also uses his home offices in his role as chief economist for TD Bank Financial Group's U.S. arm, TD Bank, which has headquarters in Cherry Hill, New Jersey, and Portland, Maine.
In January, Naroff correctly estimated unemployment would rise to 5.1 percent at the end of the first quarter of 2008, the highest since September 2005. He accurately predicted 0.9 percent GDP growth for the 2008 first quarter, a plunge from 4.8 percent in the first quarter of 2006, as the housing slowdown took a toll.
He forecast 12-month inflation at 3.9 percent through March 2008, which turned out to be slightly less than the actual 4 percent rate.
Out of Whack
Naroff makes his forecasts by zeroing in on areas such as housing that diverge from normal behavior. Then, he crunches the numbers to see if the trend can continue. If not, he calculates what will happen to the economy when what's out of whack goes back to the norm.
``If there's an overarching excess or segment of the economy that seems to be out of sorts with the normal pattern, whether it's weakness or strength, then you look at it to see if it's sustainable,'' he says. ``You know it's going to revert.''
Naroff knew that housing prices had grown nationwide at the fastest pace in at least a century, almost doubling from 2000 to '06, according to the S&P/Case-Shiller Home Price Index of 20 U.S. cities. He expected them to start falling back.
Since the middle of 2006, prices have skidded 20 percent and sales have tumbled about 36 percent. The housing rout spilled into the economy, costing the U.S. 760,000 jobs this year through September.
Fuel Costs
Gasoline prices that topped $4 a gallon during the summer crushed consumers, already the most cautious in almost three decades. All of that put the nation on the brink of its first recession since 2001 even before the meltdown on Wall Street.
As credit flows remained clogged in early October, Naroff forecast the economy shrank at a 0.8 percent rate in the third quarter and will contract at a 0.4 percent pace in the fourth. He says growth will rebound to a 1.6 percent rate in the first quarter of 2009.
``What's happening in the markets is causing both households and businesses to become extra conservative,'' Naroff said Oct. 8.
Naroff and the others were the most accurate at predicting unemployment, where one of every five forecasters was on target. They were the worst on GDP growth, which is the most complex to get right because it incorporates variables such as consumer spending, government outlays and trade.
One-Time Factors
Difficulty in forecasting GDP is exacerbated by unexpected one-time factors, such as this year's government rebate checks, which boosted consumer spending. Also, small shifts in the monthly timing of events, such as whether carmakers cut output in June or July, can make a difference in which quarter is affected.
GDP estimates for the first quarter of 2008 ranged from minus 1.4 percent to 4.1 percent growth. Only Naroff and two other forecasters of the 65 surveyed on this measure were right. To reflect the difficulty forecasters have with GDP, Bloomberg double weighted it in calculating the winners.
Unlike Naroff, Jan Hatzius has had a front-row seat for the turmoil as chief U.S. economist for Goldman Sachs Group Inc. in New York. He was Bloomberg's top forecaster on unemployment and the Fed's target for its fed funds rate.
In early October, Hatzius painted a scenario of intensifying gloom.
`Deeper' Recession
``The recession that we have been forecasting now looks likely to be deeper and longer, taking the unemployment rate to 8 percent by late 2009,'' he said on Oct. 3.
Hatzius, 39, was one of the most prescient in predicting the Fed would cut rates sharply beginning in 2007. Hatzius also predicted unemployment would rise. In early October, he said the U.S. jobless rate will end 2008 at 6.6 percent, up from his previous 6.2 percent forecast.
Hatzius, who said the housing slump would shave 1.5 percentage points from GDP in 2007, sees the biggest economic risk as what he calls the feedback loop between real estate and credit markets.
``Greater economic weakness might feed into bigger house- price declines, which might trigger larger credit losses and in turn a greater amount of credit tightening,'' he says. ``We're in very uncharted territory.''
Hatzius predicts that growth came to a screeching halt in the third quarter, and that there will be a 2 percent contraction in the fourth and a 1 percent decline in the first quarter of 2009. He sees no growth in the second quarter of '09 and a 1 percent increase in the third.
`Intense Distress'
``The intense distress in financial markets -- which seems unlikely to dissipate quickly -- further darkens the outlook,'' Hatzius says.
Hatzius, a German citizen who has a doctorate in economics from Oxford University, wasn't among the 10 best overall forecasters because under Bloomberg's methodology, his accuracy was low on the double-weighted GDP.
John Dunham, the top forecaster for the consumer price index, looks at the economy from the ground up as president of Guerrilla Economics LLC in Brooklyn, New York. Dunham weighs in on indicators as part of his reporting for such trade groups as the Washington- based Beer Institute. The research requires him to emphasize commodities, a fact Dunham says helps him get a handle on inflation because he looks at things such as barley prices.
``Our job is to answer questions and tell stories about what is going on,'' he says.
Beer, Oil
Dunham, 44, recalls that as oil prices started to climb, many clients -- the beer makers in particular -- grew anxious. Energy accounts for about 1.5 percent of the cost of manufacturing beer that's sold to a wholesaler. So when energy costs doubled in the two years through July 2008, the price of each barrel rose by about $3, he says.
``We're not theoretical economists,'' says Dunham, who got his Master of Business Administration from Columbia University in New York. ``There are data guys, and there are academic guys and then there are the story-telling guys.''
Dunham, whose office is across the East River from Manhattan, still thinks inflation is too high.
``The Fed should be raising rates, but they are unable or unwilling to do so,'' he says.
On Oct. 8, the central bank made a surprise half-point cut to 1.5 percent. He says policy makers should stop trying to avoid a downturn, which would wring excesses out of the economy.
``You take your recession and you move on,'' he said in early October.
Dunham says the third quarter of this year was the weakest, with a 1.2 percent contraction. That will be followed by a half- point decline in the October-to-December period. He looks for growth of 1.7 percent in the first quarter of 2009 and 2.2 percent for the year.
Carnell, GDP
Rob Carnell, this year's top GDP forecaster, made his prediction from an office more than 3,000 miles from Wall Street. Carnell saw the housing slump from London, where he's chief international economist at ING Financial Markets, a unit of ING Groep NV.
He and his team of analysts had studied real estate booms and busts in the U.K. and Australia and noted similarities across the Atlantic. In late 2005, they put out a report called ``Trouble If Not Bubble.''
``The U.S. housing market was overextended and was going to start to soften dramatically into '06,'' says Carnell, 41, who has a Master of Arts in economics from McMaster University in Hamilton, Ontario.
In a November 2006 note entitled ``From Bubble to Rubble,'' Carnell said consumer spending would take a hit as people withdrew less equity from their houses. He was right: The 3.8 percent rise in the pace of spending growth in the first quarter of 2007 dropped to 1 percent by the fourth.
Fed Action
During the slowdown, the Fed began the fastest series of rate cuts in two decades. In the seven months through April 2008, the central bank brought the fed funds target rate down 3.25 percentage points, to 2 percent. The Fed acted even as oil rose from about $80 a barrel to almost $120, igniting inflation fears and debate among policy makers. Carnell, unlike Dunham, says the Fed must cut rates to buoy the economy.
``It needs something,'' he said on Sept. 17, a day after the central bank held rates steady at 2 percent before its October cut.
Carnell predicts the economy contracted at a 0.2 percent pace in the third quarter and will shrink at an 0.8 percent rate in the fourth.
Naroff, who was Bloomberg's top GDP forecaster in 2004, was a distant 18th this year. Helping him win the overall title were his second-place ranking for CPI, a third-place ranking for fed funds and the eighth-best showing in unemployment. He says it's been an advantage to work on his own -- particularly during turbulent times.
Griffey the Cat
He doesn't have bosses to answer to or colleagues to distract him, unless you count his cat, Griffey, who occasionally saunters across his computer keyboard. Naroff is free to step away from his desk at his vacation home in Margate City to bicycle along the shore. In Pennsylvania, he burns nervous energy by planting shrubs.
Naroff's career has combined elements of the arts and sciences. In the 1960s, he worked toward a Bachelor of Science in chemistry from the State University of New York at Stony Brook.
Then, believing economics was more relevant to that tumultuous decade, he put in another year and added a Bachelor of Arts in that subject. Naroff topped off his Ph.D. pursuit at Brown University in Providence, Rhode Island, with a summer driving across Canada.
``I suffered from a form of academic ADD,'' he jokes, referring to an inability to focus. ``Most of my friends followed the same path of research.''
Art of Forecasting
Naroff taught economics and then quit his tenured professorship at the University of Massachusetts, Amherst, to spend more than a decade as a business economist for the former First Union Corp. in Philadelphia. In 1999, he set up his research and consulting firm, where he savors the freedom to go outside to think.
``Forecasting is an art,'' he says.
There's also an element of luck. Naroff, who was named best overall forecaster for 2007 by the National Association for Business Economics, recalls that when he received the award, he joked he'd used the ``CAT'' method of forecasting.
The acronym didn't stand for Co-Autonomous Transformation, a term he made up for the occasion, but rather for his cat. Naroff says most mornings, Griffey, named for his son's favorite baseball player, Ken Griffey Jr., pads across his keyboard. There, Griffey taps out his own take on the course of events.
During this unprecedented time of collapsing banks, frozen credit and global financial turmoil, forecasters are coaxing their overwhelmed economic models to predict what's next. In such uncharted terrain, even a cat walking on a keyboard may have a shot at getting it right.
How We Crunched the Numbers
To identify the best economists, we focused on estimates submitted to Bloomberg News for four key U.S. indicators: the consumer price index, the federal funds target rate, gross domestic product and unemployment. We compiled estimates made by the economists in January of 2006, '07 and '08 for the four quarters of the year (or, if they didn't have a forecast in January, we counted the last forecast of the previous year).
We wound up with 10 forecasting periods: the eight quarters in '06 and '07 and the first two quarters of this year. We included only economists who made a total of six or more forecasts for each indicator, including at least one forecast for '08.
To determine the economists' accuracy rating for each indicator, we calculated the error for every forecast by subtracting it from the actual figure. We totaled the errors -- double weighting 2008 because of its importance -- and calculated their margin of error, which we then subtracted from 100.
To get overall scores, we added their margins of error for all four indicators, giving GDP a double weighting because it's so difficult to forecast. Then we divided by five and subtracted the result from 100.
The overall winner, Joel Naroff of Naroff Economic Advisors, had the highest accuracy score. On average, his forecasts deviated least from the actual figures.
To contact the reporter on this story: Bob Willis in Washington at bwillis@bloomberg.net.
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