Buttonwood in the Economist

The Buttonwood columnist in the Economist writes,

Two groups seem to be staring at each other in mutual incomprehension at the moment; investors and economists. Judging by the behaviour of stockmarkets so far this year, the former are very worried about the global outlook. But the latter think investors are panicking for no good reason.

To examine the validity of this statement, we must first ask how both groups form their global outlook, and hence – are their world views so very different?

An economist attempts to explain economic phenomena through theory and data, assuming a rational market and a causal relationship, and so do investors. However, an investor looks for fundamentals and facts on the ground that would give an anchor to the price of assets while gauging the fear and sentiment against this reference point, all the while keeping in mind that the market can stay irrational for far longer than one can stay solvent. That is the key difference.

Whereas an economist’s incentive might be to amend his DSGE model, an investor gets compensated to be forward looking and take risks based on a variety of outcomes. Risk-taking and the possibility of being rewarded or punished for it gives a different shade to the art of forecasting and projections. China is indeed a good example from the Buttonwood article: an economist might claim that the growth is alive and well, but an investor with interests in a company conducting sales in China should be justifiably worried. Both are right in their summation. Andy Mukherjee put his finger on it: while China may still be growing at an official rate of 6.9%, sales of listed Chinese corporations are down 3.6%.

Bear in mind, the loss incurred for an economist’s wrong theory is non-quantifiable, albeit reputational. For an investor, she may profitably gain or suffer losses based on how accurate the hypothesis is in terms of timing and figures.

If the fear and irrationality overshoot the fundamentals, then contrarian investors with strong convictions would want to find a suitable entry point and vice versa if exuberance overcomes reasons. This observation of sentiment is usually missing from an economic analysis, because rationality including the assumptions forming the rationality are assumed and not spelled out by studies run by economists.

On the other hand, prudent investors must take into account of other investors’ irrationality. Hence, uncertainty, valuation and volatility in the markets are key words for an investor whereby an economist will try and rationalise a strong t-stats result.

The Buttonwood columnist quotes an uninspiring Olivier Blanchard post,

To a large extent, herding is at play.  If other investors sell, it must be because they know something you do not know.  Thus, you should sell, and you do, and so down go stock prices.

I have written about herding many times in my previous posts. As an economist, I do worry about herding, market structure and the information cascade. As an investor, I profit from herding behaviour and momentum.

Having said all this, perhaps Buttonwood is correct in that economists and investors should reconcile their differences. In A Practitioner’s Defense of Return Predictability, I wrote, “I am very much in favour of practitioners coming together with academics to combine their knowledge and experience. Whereas academic papers often culminate in a t-statistic for a single idea, practitioners will often not be satisfied until they include a few time-series charts and spend some time thinking about implementation issues”.

The Buttonwood columnist ends with,

The big problem, however, is that market signals are not what they used to be. Central banks are still buyers, or huge owners, of government bonds; are yields really a measure of investor sentiment? Very low, or negative, interest rates dissuade investors from holding cash and encourage them to buy risky assets; so are equity prices and corporate bond yields a “true” measure?

That is a very good question, I have often wondered what the “true” measure is and written quite a bit on earnings and risk premia. Market (timing) signals are also an interesting topic – an investor that wants to profit needs to heed them. Are market signals less effective? Some perhaps, if taken individually, but in combination, I believe they still bring in the alpha. As I wrote before,

“In this paper, they attempt to combine a vast array of ideas rather than focusing on one small marginal addition to the literature which, in my opinion, is one of the secret ingredients of quant investing. A single inefficiency might not be enough to convince the believers of market efficiency, but a combination of several insights can form a reliable trading strategy.”

It was a tough day today, in any market. Looking ahead while wearing both hats, I would say, proceed extremely cautiously. Don’t fight very strong trends and in times like these, more than ever, cash flow is the key metric.

The one thing my economist and investor sides can both agree on, is that uncertainty is up and forecasting has just become harder.

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