Tuesday, May 26, 2009

On Economic Forecasts..Chance Favors a Prepared Mind

Quote from speech by Ben Bernanke at Boston College Commencement 5/22/09:

“As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy. The Federal Reserve, therefore, devotes substantial resources to economic forecasting. Likewise, individual investors and businesses have strong financial incentives to try to anticipate how the economy will evolve. With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming. Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect."

"In some ways, predicting the economy is even more difficult than forecasting the weather, because an economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make. To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism.”

“In planning our own individual lives, we all have a strong psychological need to believe that we can control, or at least anticipate, much of what will happen to us. But the social and physical environments in which we live, and indeed, we ourselves, are complex systems, if you will, subject to diverse and unforeseen influences. Scientists and mathematicians have discussed the so-called butterfly effect, which holds that, in a sufficiently complex system, a small cause--the flapping of a butterfly's wings in Brazil--might conceivably have a disproportionately large effect--a typhoon in the Pacific. All this is to put a scientific gloss on what you probably know from everyday life or from reading good literature: Life is much less predictable than we would wish. As John Lennon once said, "Life is what happens to you while you are busy making other plans."

"Our lack of control over what happens to us might be grounds for an attitude of resignation or fatalism, but I would urge you to take a very different lesson. You may have limited control over the challenges and opportunities you will face, or the good fortune and trials that you will experience. You have considerably more control, however, over how well prepared and open you are, personally and professionally, to make the most of the opportunities that life provides you. Any time that you challenge yourself to undertake something worthwhile but difficult, a little out of your comfort zone--or any time that you put yourself in a position that challenges your preconceived sense of your own limits--you increase your capacity to make the most of the unexpected opportunities with which you will inevitably be presented. Or, to borrow another aphorism, this one from Louis Pasteur: "Chance favors the prepared mind."”

Complete speech available:

At WS Wealth Managers, we always tell our clients that Preparation is more important than Predictions which is another way of saying what Louis Pasteur said: “Chance favors a prepared mind”. Our view is that predicting the short term micro or macro economic future is like predicting the weather—we can only speak in probabilities. On the other hand, predicting what will happen can be done with much more precision than predicting when it will happen. (Assuming the predictor is intelligent and informed.) We can predict that Summer follows Winter. We know that Winter nor Summer do not go on forever. Being prepared is all about knowing what will happen—knowing that when it happens, you will be prepared to take a certain action that benefits you.

Saturday, May 16, 2009

Hope vs Worry

In February I wrote: “During periods of high volatility, and even in the middle of very tough economic times, markets can go up a lot.” This continues to be a true and important statement. Since the March 9 “bottom” stocks are up a lot. Is it time to throw caution to the wind? I think not.

Markets are created by buyers who have hope and sellers who have worry. Times of change are characterized by the tension of two competing fears: The Fear of Loss vs. the Fear of Missing Out.

Markets in the short term are driven by these emotions and sentiment. Hence, logic is almost useless as a predictive tool in the short run. In the long term however, markets are priced by the profitability of companies, which is driven by economic activity and increases in productivity over the long run. Logic can be very useful as a predictive tool in the long run.

From it’s peak of nearly $65 trillion in 2007, World Stock Market Capitalization fell below $30 trillion in March 2009. This type of decline has no explanation other than a global panic driven by a level of emotion (fear) and a fall in housing prices that I have not seen in my lifetime. Since this “bottom” in March, it has risen dramatically. In April alone, it rose $4.2 trillion. The only logical explanation is the recent rally is simply a realization that the previous decline was overdone.

You will hear the “worry” crowd pontificating that markets cannot recover until the economy improves. There are many signs that the world economy is still in a great deal of trouble. Unemployment is rising. House prices may fall further. People are spending less. The “hope” crowd however will point out that there are many “green shoots” or signs that things are on the mend: Consumer Sentiment is up; Housing has never been so affordable; Governments worldwide are proactive and are implementing unprecedented pro-growth initiatives; There is a great deal of cash sitting on the sidelines, earning little interest income and poised to enter the stock market. Both crowds are correct. But, most importantly, markets tend to turn upward ahead of the economy.

Within the “worry” crowd is a group who fear that our best times are behind us. They not only fear another decline in the short term but also a long term reduction in enterprise profitability and hence value. Within the “hope” crowd is a group that figures the worst is over and that good times will soon return. Both groups are probably incorrect.

The point here is that good times will return. The unknown is only really how soon and how fast. World stock markets were probably overvalued at $65 trillion in 2007. (Knowing what we now know about excess borrowing and debt.) They were undoubtedly undervalued at $30 trillion in 2009. A case can be made that their “fair” value is between $40-50 trillion. Markets therefore have room to rise. But, their rise is likely to be a roller coaster ride of ups and downs: Hope vs. Worry.

So, investors with a long term outlook should stay invested with a cautious outlook and cash should be deployed cautiously. Continued recession and a recovery with inflation are both very possible outcomes. What you invest in will be very important. Good advice has never been more valuable.