Keep the Economists off the Trading Desk

 “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.”
- Peter Lynch, greatest stock market investor of all time

Up until 2008, it was a given that economists had no business anywhere near the trading desk. Their work was important as a framework toward understanding the interplay between the markets and the real world – but that was about the extent of it.

Then post-crisis, some of these guys became “rock stars”. Which is fine up to a point. All of us market participants and investors can learn a lot from their research. But when they started putting out newsletters and alerts and “monitors” to traders and fund managers – as though there was some sort of actionable message embedded in their reports – things got strange. All of a sudden there were economists making equity market buy and sell calls in the media and there were even economics reporters “grading the trade” on TV.

Economics is extremely important to understanding the world in which we live, but the linear application of it can be deadly with actual money on the line. Thinking that low GDP growth would mean low stock returns would have sat you out of one of the best bull markets in history these past few years. It also would have made you miss the bottom of the European stock market and led you to have guessed that China, with its world-beating growth numbers, would outperform (it’s actually had the fastest economic growth and the poorest stock market returns).

The reality is that there is no such positive correlation over various periods of time between economic data and stocks in any given country. And economic data in the short-term is every bit as unpredictable as stock market behavior, so basing a forecast for one on what you predict for the other is like picking out a sports jacket and slacks in the dark and hoping one is not navy while the other is black.

A study from the London School of Economics concluded that choosing where to invest based on favorable economic factors is actually a recipe for underperformance. Researchers Dimson, Marsh and Staunton said “take the records of 83 countries from 1972 to 2009 (the most comprehensive set available) and rank them by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the preceding five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.” Another study by BNY Mellon looked at the S&P 500 versus US economic growth from 1970-2012 and concluded that there is no link whatsoever between the two.

PIMCO provides us with a perfect example of this mismatch and the damage it can do – each year it hosts a conclave of a few hundred of the smartest people in the world, they call it the Secular Forum. At the conclusion of this multi-day event, PIMCO issues a proclamation containing the conclusions they’ve drawn and the forecasts they’re making as a result. The good news is that the firm has been exactly right about, well, everything since the start of the post-crash period. They actually invented the New Normal concept of persistently low economic growth, high unemployment and increasing social inequality back in 2009 – Bullseye!

The problem is, as Mohamed El-Erian was forced to admit at conference this spring, that they nailed the economy and yet they got the markets completely wrong. If you had listened to PIMCO’s economic forecasts and then done the opposite of what they did with your portfolio, you’d have done spectacularly well.

My friend Eddy Elfenbein, a bottoms-up value stock picker who’s been blogging at Crossing Wall Street since 1964, has made this point before. In a post this fall, Eddy showed a scatterplot chart of the annual change in price for the S&P 500 versus annual nominal gross domestic product. Not only does there appear to be no correlation whatsoever, you could squint and almost perceive a slightly negative correlation!

Bloomberg News reminds us of just how disconnected economics and stocks can be sometimes with an article about the top-performing market in the world, which just happens to exist amidst the world’s worst economic story of the decade:

Greek stocks, once shunned by investors concerned that a default would force the nation out of the euro, are beating almost every market in the world as a six-year recession eases and new investors consider purchases.

Since June 5, 2012, two weeks before MSCI Inc. gave notice it may reclassify Greece as an emerging market, the country’s ASE Index has surged 146 percent, trimming the decline from its 2007 peak to 79 percent. The gains topped all 94 national benchmarks globally in the period, except Venezuela, according to data compiled by Bloomberg. Yields on Greece’s 10-year government bonds have dropped to 8.31 percent from a peak of 33.7 percent in March 2012.

Josh here – let’s talk about the state of the Greek economy.

The country is unable to borrow without the assistance of its Northern European benefactors backstopping and haircutting and bailing-out and inspecting. Debt-to-GDP will peak out in the next year at some 176% – a disastrous number for any country, especially for a country that does not have the ability to use currency deflation to make it more manageable. In the meantime, over the last five years, Greece has seen a full 25% of its economic output literally disappear – vaporized. This while unemployment has shown almost no sign of abating, the current rate of joblessness today stands at an unfathomable 27%.

But the stock market is not the economy.

We explained this to clients with our European overweights this past spring (You’re overweighting Europe?!?!?) and are currently doing the same with our investments into the much-hated materials sector.

Stocks trade based on three things: sentiment, valuation and trend. Yes, economic data feeds into these things, but it is up to the trader or investor to determine their combined favorability, an economist does not do that sort of work. The Greek stock market was the most hated in the world (sentiment), one of the very cheapest on valuation (four times earnings at the bottom!) and the trend had only one direction to go (the Greek stock market, called the ASE, had hit a 22-year low in June of 2012 and was down 90% from the 2007 high).

Investors should read voraciously about the economy and be up to speed on the data and prevailing opinions at all times. But the acquisition of this knowledge should be in service of a greater contextual understanding of the world around us – and not as a trigger to do something in our portfolios.

Sources:

Greek Recovery Makes Stocks World’s Best as Paulson Buys (Bloomberg)

The Economy and the Stock Market Aren’t the Same (Crossing Wall Street)

Growth and the Markets (The Economist)

Notes from the PIMCO Investment Summit with Mohamed El-Erian (TRB)

 

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