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When economists get it wrong

21 September 2009 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Modern day investors are obsessed with numerical data and statistics. They want to stay up to date on stock market levels, exchange rates, commodity prices and individual stocks on a daily (if not hourly) basis. But while their eyes are glued to screens and printouts they often miss out on developing market trends and themes. What questions should we be asking as we assess post-crisis investment opportunities? Eric Lonergan, director of asset allocation at M&G Investments in London, shared his somewhat unconventional approach to spotting investment trends at a Prudential Investment Conference held in Sandton last week. The conference was titled From Armageddon to Bubble in Just Six Months!

One of the most valuable lessons for a fund manager or economist is to realise how little we actually know about likely future events. As we shrug off the overhang of the latest financial crisis we remain uncertain of the path, speed or duration of the market upturn. According to Lonergan, “the long-term enduring consequences of the crisis are highly unlikely to be what we expect them to be.”

Three mistakes economists make

Lonergan noted that economists suffer from three serious afflictions. The first is the so-called ceteris paribus bias. Professionals in the industry are guided by recent events and simply assume that everything else remains the same. “We define the world based on what’s just happened to us!” said Lonergan. Financial market regulators are particularly guilty of this. “There has been a lot of financial regulation over the last 20-years,” said Lonergan, adding that the dotcom collapse of the late 1990s triggered a frenzy of market interventions. These interventions were aimed at preventing a repeat of the valuation crisis (or equity bubble) that triggered the collapse. As it turned out the next equity market crisis came as a result of non-performing loans. It’s a mistake we’re likely to repeat. Lonergan noted that while today’s regulators are thinking of ways to regulate asset-prices and liquidity it’s highly unlikely to be the source of future collapses.

The second problem economists have is consistency or commitment to a particular view or belief. “If you are going to have a view, it might be best to keep it to yourself!” said Lonergan. It’s extremely difficult for a public figure to change a long-held view without looking silly. Ordinary investors are guilty of this flaw too. Regardless of recent positive economic data many investors struggled to cast off their recession mentalities. They ignored objective assessments of the facts as the world came out of recession. As a result these investors remained in cash (at yields close to zero percent) while the global equity market recovered strongly.


And finally – economists are simply not that good at economics! “One of the problems is that economists devote too much of their resources to cyclical economic data,” said Lonergan. The best demonstration of this is the oft-referenced US household debt ratio. On a cyclical measure this ratio is at the worst level in history; but if you compare it on a cross-sectional basis to other OECD countries the US household debt ratio is rather ‘middle of the road’.

Missing the critical trends

The most valuable economic lessons are learned from observing past crisis events. After the Asian banking crisis of 1997 and 1998 experts made a number of structural assumptions. They determined that Asia would experience a Japan-style economic stagnation. Lonergan noted that Japan remains “a nightmare in our collective consciousness.” Investment experts also believed China was on the brink of collapse due to worrying non-performing loan statistics. And they predicted a global recession!

But this scare mongering was way off the mark. Nobody picked up on the eventual post-crisis economic trends. In the years directly after the Asian banking crisis China’s share of global GDP rose strongly, the technology boom had a major impact on global GDP growth and “policy response to the deflationary shock dramatically increased financial intermediation and house price inflation in the developed world.” In other words – the expected trends failed to emerge – and the trends that eventually played out had not even been imagined. The lesson, said Lonergan, is that economic outcomes are rarely as expected.

There are plenty of examples of such phenomenon. A respected professor of finance, quoted in the Financial Times on 14 December 2008 observed that “the global decoupling theory seems to have died a well-deserved death.” Less than a year later his ‘expected outcome’ lay in tatters. In the 12-months to August 2009 developed markets shed 18.2% (S&P 500) and 12.7% (Euro Stoxx 50) while emerging markets rocketed. The Shanghai Comp was up 30.8%, India’s Sensex 10.6% and Brazil’s Bovespa 9%. Thus equity performances in developed and developing economies (on the surface) contradict the professor’s conclusion.

Exploiting flaws in conventional thinking

History shows that prevailing structural views can be hopelessly wrong. Lonergan suggests investment professionals use this knowledge to exploit extremes in data series and profit from rapid changes in price. Using this strategy he suggests being long developed market equities and ‘short’ US 2-year debt.

Editor’s thoughts: Recent rand strength means South African investors have a great opportunity to move some of their spare cash offshore, possibly into US and other developed economy equity markets. Would you consider moving funds offshore with the rand better than R7.50 to the US dollar? Add your comments below, or send them to gareth@fanews.co.za

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