Economists and the Stock Market

By Jeff Harding.

It has been my experience over my years of observing the financial markets and its prognosticators that economists seldom translate their correct views of the economy to investment success. I am speaking mostly of those economists who are not captive in-house economists, but those who toil in academia or sell research.

I speak especially of my fellow advocates of free market economics, whether Monetarists or Austrians. And this is something that has bothered me for a long time. The Keynesians don’t seem to get it right either.

What reminded me of this recent Bloomberg article about Nouriel Roubini:

In July 2006, Roubini predicted the financial crisis that led to $1.6 trillion in credit-related losses and writedowns. He forecast a “catastrophic” meltdown in February 2008, leading to the bankruptcy of large banks with mortgage holdings and a “sharp drop” in equities.

So far, so good.

Roubini told Bloomberg Television on May 13 that the stock market’s rally “might fizzle out,” citing expectations for weak growth in earnings. On March 9, he said it was “highly likely” the S&P 500 would fall to 600 or below because of plunging profits, an accelerating contraction in the global economy and a deteriorating outlook for banks. … The index reached a 12-year low of 676.53 that day and has since climbed for almost six months. …

Anyone attempting to apply Roubini’s wisdom to stocks may be forgiven for missing the biggest rally since the 1930s as the Standard & Poor’s 500 Index climbed 52 percent in six months. While Roubini said in March the advance was a “dead-cat bounce,” that it may “fizzle” in May and warned in July that the economy’s “not out of the woods,” the MSCI World Index was posting a 58 percent gain, the largest since it began in 1970.

Lazlo Birinyi, made famous on Louis Ruckeyser’s show, said of Roubini:

“He may have missed this year’s bull market because Roubini isn’t focused on stocks, according to Birinyi.  Roubini has “done a very good job on the economy,” Birinyi said in an interview Aug. 24. “Our approach is to try to understand the market and not try to do much more than that.”

Peter “As Seen on TV” Schiff is another. He runs EuroPacific Capital and made a very big name for himself predicting the collapse of the economy. There are many film clips on YouTube where he famously embarrassed many Wall Streeters and economists by his insight into the economy. Peter is of the Austrian School of economics and does an excellent job in articulating these ideas.

There is one hitch to Schiff and that is in making money for his clients. He predicted global equities would be the place to be after the crash and he also predicted that we’d be in hyperinflation. Neither of those things worked out well for him. While I enjoy his film clips, I have tuned him out.

To be fair to Roubini and Schiff, hardly any economist predicted the market collapse.

I can go back much farther than this and think of the many crashes and hyperinflations that were predicted by Austrian and Monetarist luminaries that never happened. No, I won’t name names.

So why is that?

For several reasons.

Friedrich von Hayek, articulating his Austrian epistemology, said that economists can predict large trends in an economy, but it’s almost impossible to know how things will unfold in the short term. And this is really the key to it. There are millions of pieces of data. How can you even know if you have the right data to predict with certainty what’s going to happen in six months? The record shows that you really can’t. And those that do are probably lucky.

Nassim Taleb and Benoit Mandelbrot bring up the fallacies investors labor under in the evaluation of risk and the role of randomness. I believe Taleb is an adherent of Hayekian epistemology. Their point in their studies of randomness and behavioral economics (a form of epistemology–the science of how you know what you know – or don’t know) reveal that it’s almost impossible to know if success comes from skill or luck. They believe it’s mostly luck. And, yes, some very few people can be lucky for a long time. They point out, as proven above, that few people see disaster (Black Swans) coming.

Personally I would like to think that those investors showing extraordinary success over a long period of time, say 20 or 30 years, are probably more skillful than they are lucky. Whatever.

So how do you make money in the markets? I don’t really know, but there are people out there who are good at it for for five or ten years until they blow up.

Taleb’s strategy is to put most of your money into conservative investments that won’t lose, such as Treasury bonds and notes, and make some big bets with the rest (10% to 20%), depending on your risk tolerance. He favors buying out of the money options and wait for the market to crash. He and his affiliated firm, Universa Investments, did just this and made a killing for their clients in 2008.

It’s a fallacy to think that you’re not betting.