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.

Paul Krugman writes in today’s New York Times:

How bad is it? Well, I’ve never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.

Credit — lending between market players — is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.

But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.

We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis.

I agree. Although it doesn’t absolve the millions of Americans who got mortgages which they did not understand for houses which they could not afford, using a system of valuation rigged to artificially pump up prices… the bulk of the blame has to be liberally heaped on the previous Fed chairman.

He poo-poo’ed repeated concerns about derivatives and who refused to acknowledge a full-blown real estate bubble even as it inflated under his nose.

Of course, now he not only agrees that there is and was a bubble, he now even calls it by that name and goes as far as calling it a “global housing bubble”. But just to be clear, it isn’t his fault in any way whatsoever.

Retirement does wonders for the brain.

Wouldn’t you love to take all your losses and combine them to magically create a profit?

Parrondo’s Paradox says this is theoretically possible. According to Parrondo’s paradox, two games guaranteed to make a player lose all his money will generate a winning streak if played alternately.

In other words, alternate between listening to Jim Cramer and listening to Richard Bernstein

Although it certainly wasn’t invented because the physics professor, Juan Manuel Rodríguez Parrondo, was seeking stock market profits, it has gone on to inspire wide ranging ramifications including the mechanics of evolution and managing investment portfolios. Before you get excited though, bear in mind that the two “games” have to be related to one another before the paradox has any effect. Here’s a visual representation of Parrondo’s Paradox.

From the New York Times article:

Economists are studying Parrondo’s paradox to help find the best strategies for managing investments. Dr. Sergei Maslov, a physicist at Brookhaven National Laboratory in Upton, N.Y., recently showed that if an investor simultaneously shared capital between two losing stock portfolios, capital would increase rather than decrease.

“It’s mind-boggling,” Dr. Maslov said.

“You can turn two minuses into a plus.” But so far, he said, it is too early to apply his model to the real stock market because of its complexity.

I do remember reading somewhere that two trades which by themselves can be unprofitable, can be combined to create a profit. I think it was in the Wizards series by Schwager where a trader was talking about options. I never quite understood how this was possible. Maybe he meant Parrondo’s paradox. Does anyone recall that excerpt? ring any bells?