My favorite blog this week, "Why the Economy is Not Relevant to Investing", came from Million Dollar Journey authored by Ed Rempel. I came across the site as I trawled Biz of Life's Blogroll.

Ed Rempel presents a pretty forceful case. I have long thought that the mathematics of investing has a certain fuzziness about it that prevents us from getting a clear picture of what is happening in the investing world and prevents anyone from coming up with a system to "beat the market." My field in graduate school was econometrics, and, in studying mathematics and statistics and econometrics, there comes a point where you realize that people try to fit the real world into the math in a simplified fashion. Specifically, assuming the real world is linear is real convenient.

In fairness, some relationships are linear. For example, if you collect data on grade point average and hours studied, you get a fairly linear relationship. Go beyond simple cause and effect situations, however, and, again, it gets non-linear real fast.

**Where's the Fuzziness?**

Think about this. Suppose there is value to the stock investor of knowing GDP - the broadest measure of economic output. First off, GDP is difficult to forecast - especially at turning points. Even the Bureau of Economic Analysis (the entity that decides the economy is in a recession) can't really decide a recession is in place until sometime after the fact. Secondly, GDP is reported with a significant lag and revised twice after that! This doesn't include the periodic longer-term revisions that take place. Finally, we have to get "news" out of the information - i.e. we need to know how we differ from expectations. All of this compounds the fuzziness. But suppose we had perfect information. Suppose we knew that GDP was going to be +3.2% this quarter, an increase from 2.1% the previous quarter, and suppose we knew this on day 1 of the quarter? Would this information be valuable? I realize that stocks are affected by more, a lot more, than GDP. But this just adds to the fuzziness. For instance,if GDP ratchets higher and at the same time the Fed makes a surprise policy change, then clearly all bets are off. The reader can think of a million examples like this.

Mr. Rempel's post got me to wondering if a game using real-life info along these lines couldn't be set up and his thesis examined statistically. Suppose we draw cards and they have two pieces of info: the amount real GDP is going up (or down) this quarter versus last quarter (we're assuming we know a lot more than we really know in the real world) and the level of the S&P 500 on the first day of the quarter. As an investor, we decide to increase or decrease our allocation from 50/50. Would we be able to add value?

This easily could be extended. Add in the unemployment rate for each month of the quarter, assuming we had the perfect crystal ball. Add in Fed policy in terms of the target rate for the federal funds rate.

It seems to me that an energetic person could run with this and set up an interesting game/experiment along these lines. Maybe two or more "investors" go at it at the same time, as in the real world, adding another layer of fuzziness: people reacting differently to the same info.

Anyways, I enjoyed Mr. Rempel's post and I think he has given us and those who stay riveted to CNBC plenty to think about.

That is very interesting and points out just how many factors would need to be included into a model in order to get an accurate model. That's challenging because as you increase the number of variables within a model you diminish the statistical power to discriminate between the variables.

ReplyDeleteAre you a speculator or an investor? The speculator might care about short term GDP fluctuations and try to come up with a sophisticated computer model to tell him how to place his bets, while the long-term investor knows that between inflation and real growth GDP is headed higher over the next 20 to 30 and just rides the wave of speculation up and down knowing the long-term direction is higher.

ReplyDeletere: Shawn and Grouch ... I'm not taking a position so much as puzzling through a conundrum. Can it be that all the resources we spend studying the economy to be able to derive something useful for investment purposes is totally useless. Think of all the magazine articles, all the talking heads on CNBC etc. Is it a total waste of time to read and listen to those pundits?

ReplyDeleteRobert,

ReplyDeleteMy point was if someone is a speculator they might care about the talking heads, and ever uptick and downtick in the market, trying to squeeze out a positive trade wherever they can. If someone is an investor, they put their money into the proper allocations, turn off the TV, go to sleep for 20 - 30 years and wake up a wealthier person. It's not quite that simple, but the investor needs to tune out the noise.

Re: Grouch I see your point. I'm just trying to get at the idea behind the original post which I believe was that analyzing and forecasting the economy is useless for speculator or investor. I'm asking if you knew exactly what GDP was for every quarter over the last 5 years on the first day of the quarter would it have helped you in your asset allocation? Would you have reduced your equity position a bit because you knew how far down GDP was going to drop etc.?

ReplyDeleteLet me introduce a different angle. I think we would agree that if we knew exactly the earnings to be reported for every stock in the S&P 500 two days before it was to be reported then we would agree that would be valuable information. We would act on it and be able to profit.

The reason we are investors I believe is because we can't forecast the data and prices reflect the data so quickly that it is futile to try to act on the data.