Trader’s Narrative

The Survey of Professional Forecasters is little known or followed outside of econometric circles but it deserves more respect. Not because it is the oldest continuously calculated macro-economic prediction survey, but because it has an uncanny ability to predict both the start and end of recessions.

Now, I know, if you’re as cynical as me, you’re thinking, “But experts are hazardous to your financial health!” Yes, that is true. But there is wisdom in a crowd of prognosticators. With one caveat: as long as they toil away in obscurity and near anonymity. The more public their image and the higher their pay, the worse their predictions - yet another reason to ignore the chicklet-toothed “strategists” on CNBC.

The results are gathered and disseminated quarterly from the answers provided by a small group of about 40 handpicked experts. I use the term ‘expert’ because they all are required to produce forecasts as part of their normal jobs. The select group are academic, Wall St. economists, consulting firms, economists at multinationals, etc. But the one thing common to all of them is anonymity; ensuring that whatever the result, none of them can take claim for correct calls or be held accountable for terrible predictions. Although this may be appear as a disadvantage, it allows them to focus on the data. For some anonymity is liberating because it removes the potential stigma of not towing the party line (within their company or organization).

One specific survey question, referring to the probability of economic weakness has gained the most fame. This measure has come to be known by its nickname: “The Anxious Index”, given by David Leonhardt in his September 1st, 2002 article in the New York Times.

Alright, enough background. What does the data say? Here’s the chart showing the probability that GDP will fall in the following quarter:

Source: Federal Reserve Bank of Philadelphia

The recent data is the highest in the series. In the last quarter of 2008, the probability of a decline in GDP in the following quarter was 74.78% and in the first quarter of 2009 it was 73.98%. The next closest to this was back in the last quarter of 1974 (74.06%).

Interestingly enough, the probability for the present quarter experiencing a declining GDP was also the highest on record coming in at 90.14% and 94.41%. Basically the forecasters are saying, Duh? We are in a very deep recession! Why are you bothering to ask this silly question?

The Anxious Index foretells a recession when the probability of the next quarter experiencing a fall in GDP is 30% or more. You can see from the chart that it either coincides or predicts every single recession we’ve seen in the US. The most recent signal came in the first quarter of 2008 when the probability jumped to 42.91%. Of course, there were many other reasons why it was predictable at the start of 2008 that we were in a recession.

Similarly when it peaks and begins to come back down, it predicts that very soon, the economy will return to normalcy. Not immediately, but that the worst is over. The second quarter data for 2009 will be released in a little while and if it continues to head down or fall dramatically as is the pattern from previous recessions, then we have even more reason to believe that the worst is over.

Of course, that doesn’t mean that everything is suddenly peachy. It means that things stop getting worse at an accelerated rate. Then the next step is for them to plateau and then to rise.

I’ve focused on the predictions for GDP but the Forecast survey includes data on many other macro-economic variables. Follow the above link to the Philli Fed’s site and take a look around to discover more.

The Anxious Index from the Survey of Professional Forecasters seems to concur with the Index of Coincident Indicators and at the same time, manage to be one tiny step ahead:

Source: Recession, Far From Over, Already Setting Records

That isn’t surprising since the whole point of coincident indicators is to simply reflect the current situation while the Anxious Index attempts to predict the future economic situation.

So while the stock market is a forward discounting mechanism, here’s an interesting reason why, this time, the S&P 500 may actually lag GDP.

Well, do ya? If not, let me refresh your memory.

Last year, on June 4th, Morgan Stanley’s market strategists released a message telling their clients of a “Full House” sell signal. The note didn’t attract any attention until June 6th when it ignited a sell-off in the European bourses and jumped the pond to North American exchanges.

The three alarms were fundamentals, valuation and risk indicators. The latter two had already been lit and with the higher bond yields and new stats on manufacturing orders, the fundamental indicator completed the triple threat.

First of all, the note was from a respected Wall Street firm and second, it had a fierce record: it had only happened 5 other times since 1980, with each instance garnering an average loss of 15% in the following six months.

There was some confusion because the Morgan Stanley US strategist had a different take and it wasn’t clear if the call was for just Europe or whether Morgan Stanley thought it had implications for other markets (it wasn’t and it hadn’t). But before things could be cleared up, the media had latched on to the headline and the damage was done.

So why am I bringing this up after so much time has passed? It is only after time that we can look at it with some perspective and perhaps, learn something for the future.

It is so easy to get caught up in the current market-tell, whether it is a Fed decision, ISM report or whatever. What isn’t so easy is to keep one’s head and remember that these effluvia are part and parcel of the stock market’s fog of war. Also, experts are hazardous to your financial health.

Morgan Stanley’s note did spook the market into selling off significantly. But the general sentiment was too bearish already for any real damage. We had a lukewarm retest in July which didn’t reach the June lows and away we went.

It is a cliché but that doesn’t mean it isn’t true: the stock market climbs a wall of worry. Looking at the chart above it’s pretty obvious that the 3 alarm sell signal was just a brick in the wall.

See any bricks today?

UPDATE: If you’ve read the above with care, you’ve noticed that I made a mistake in the years (2006 instead of 2007). The 3 Alarm Sell Signal was in fact a very good one and this post was a silly but honest mistake.

Do you remember Didier Sornette? He is the visiting UCLA professor who became a bit of a celebrity within financial circles a few years back. Sornette co-authored a paper and then a book explaining Why Stock Markets Crash. He came up with a very sophisticated model which tried to not only explain the market but predict it years in advance.

Since at the time his model was bearish, Sornette quickly became the favourite interview subject of the perma-bears. He wasn’t right of course since the market went up instead of down.

Had he been right though, you can bet he would have become a sudden celebrity, sold millions of his dry academic book, been interviewed in Barron’s, launched a hedge fund, etc.

This is what he said in an interview on March 2003 just as the market was about to launch into a multi-year cyclical bull run:

…we predicted that the stock market will go up until the first to the second quarter of 2003 and will then start a long descend until around the end of the first semester of 2004.

And here is the graph illustrating this prediction:

At the beginning of 2006 the S&P 500 was at 1270 - approximately 500 points away from Sornette’s predicton.

Now, I’m not dredging this up in order to beat up on a well meaning professor of geophysics. My point is that listening to so-called ‘experts’ is financially hazardous to your financial health. And that includes anyone on TV, radio, or dare I say it? even a blog.

Be independant and seek understanding - from that money and success will follow. There are no shortcuts in trading or in life.

If you’re interested to learn more about experts and their predictions, listen to this lecture by Nassim Taleb: