Any Ph.D. Can Model, But Judgement Is Priceless...

by: Cam Hui, CFA

I have long been a proponent of the intelligent use of quantitative models on this blog. To illustrate my point, I compare and contrast the work of two prominent economists, Ed Yardeni and Janet Yellen. Both are at the top of their respective professions. Yardeni has been a Wall Street forecaster for as long as I can remember. He is the epitome of the practical market savvy modeler. Yellen has a sharp mind and she is about to become the Fed Chair, though her thinking appears to be more academic in orientation.

China bottoming?
Now consider how these two economists analyzed issues that arose in each of their own realms. Recently, Yardeni pointed out a possible positive divergence in China. The forward earnings of emerging market equities are correlated to commodity prices, he wrote:

Emerging markets, which account for 20% of the World ex US MSCI, have lost their earnings groove. The forward earnings for the EM MSCI rose to a new record high during 2009 through mid-2011. However, it stalled since then and continues to flat-line. As I’ve noted before, the forward earnings of EM MSCI has been highly correlated with the CRB raw industrials spot price index since the mid-1990s. The commodity index has been slowly losing altitude since the start of the year.

He went on to point out that the forward estimated margins of the components of MSCI China is rising. Since China is has a large weight within MSCI EM, then, by implication, this development should provide some positive fundamental backdrop for EM stocks.

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I have the greatest of respect for Ed Yardeni as he has been an insightful Wall Street economist since the time I started to discover girls. In this case, I would add the following caveats to his analysis of Chinese stocks:

  • How much noise is in the Street's earnings estimates? Here are a couple of sources of "noise" in Chinese companies earnings to think about:
    1. Chinese stocks have been the source of well-known accounting frauds and outfits like Muddy Waters have made a good living exploiting this anomaly.
    2. The effects of crony capitalism, opaque accounting and corporate structures may make profits elusive. Consider the case of disgraced party official Bo Xilai, who was reputed an avowed Maoist. How did the family of an "avowed Maoist" amass a fortune of at least USD 136 million, according to this Bloomberg report?
  • Don't forget the effects of government policy. China is still a "communist" country based on a command economy. In the wake of the Lehman Crisis of 2008, the government decreed that SOEs, some of which are listed on stock exchanges, go on a spending spree and state-owned banks were told to lend in order to finance this recovery effort. All duly followed orders without regard to the profit motive. As we await the policy announcements from the Party's Third Plenum (see my previous comments What Li Keqiang's 7.2% growth stall speed means and The stakes are rising for China's Third Plenary), one wildcard is the effect of direction of government policy on profit margins. The key takeaway here is revenue growth does not equal profit growth! So be careful about the assertions about profit margins.

Sometimes it is easy to forget when analyzing foreign stocks, that the companies do not live in America.

Yellen and optimal control theory

By contrast, consider the buzz in the last week that arose in some circles about the prospects for a Yellen Fed's implementation of "optimal control theory". The idea behind this approach was described in a Yellen speech on November 13, 2012 where the Fed tests out the effects of different policies and a quadratic penalty, e.g. the square of the distance, is imposed from the dual objectives of inflation and unemployment:

To derive a path for the federal funds rate consistent with the Committee's enunciated longer-run goals and balanced approach, I assume that monetary policy aims to minimize the deviations of inflation from 2 percent and the deviations of the unemployment rate from 6 percent, with equal weight on both objectives. In computing the best, or "optimal policy," path for the federal funds rate to achieve these objectives, I will assume that the public fully anticipates that the FOMC will follow this optimal plan and is able to assess its effect on the economy.

The blue lines with triangles labeled "Optimal policy" show the resulting paths. The optimal policy to implement this "balanced approach" to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016, about two quarters longer than in the illustrative baseline, and keeping the federal funds rate below the baseline path through 2018. This highly accommodative policy path generates a faster reduction in unemployment than in the baseline, while inflation slightly overshoots the Committee's 2 percent objective for several years.

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The Street got excited because, under such a regime, the Fed would be more accommodative than previously thought. The Street got doubly excited when William English, who is the head of the Fed's director of monetary affairs wrote a paper discussing different approaches to Fed policy, including optimal control theory. The combination of these events prompted Jan Hatzius of Goldman Sachs to forecast that the Fed would lower the unemployment threshold range from 6.5% to 6.0% before tapering its QE program (via Business Insider).
Whoa! Don't get so excited yet. In a separate speech on April 12, 2012, Janet Yellen cautioned against the blind use of models like optimal control theory:

While optimal control exercises can be informative, such analyses hinge on the selection of a specific macroeconomic model as well as a set of simplifying assumptions that may be quite unrealistic. I therefore consider it imprudent to place too much weight on the policy prescriptions obtained from these methods, so I simultaneously consider other approaches for gauging the appropriate stance of monetary policy.

Having worked with models that use quadratic penalties before, I know that these models can be highly sensitive to the economic forecasts and the controls can be touchy. A small change in the dial can result in huge changes in market expectations. In quant-speak, it means that outputs can be non-linear to changes in inputs. I believe that Yellen understands that and therefore cautioned against the blind adherence to this model.

This does not mean that a Yellen Fed will follow the precepts of optimal control, just that if it chose to go down that path, it would be well aware of the limitations of such an approach. Tim Duy had a more sober take on the application of optimal control theory [emphasis added]:

[I]f you focus on the possibility of lowering the unemployment thresholds to 5.5%, you should expect only a minor shift in the timing of the first rate hike. The reason for this is obvious - everyone already believes that, under the current circumstances, the 6.5% threshold is no longer meaningful. No one expects a rate hike when the 6.5% mark is crossed. A threshold of 5.5% is largely just a recognition of the reality of the likely policy path.

In contrast, the 2017 number falls out of the optimal control problem in which the Fed credibly commits to holding rates near zero through that date. That is a different policy than the threshold based guidance currently in play. And I would say that persistent concerns about financial stability make it difficult for the Fed to credibly commit to such a period of low rates, even if policymakers wanted to make such a commitment. Hence the exercise with threshold-based guidance to begin with - it is intended to capture as many of the gains of the optimal control approach as possible assuming the optimal control approach is not a realistic policy option.

Who is the more intelligent modeler?

So having read these accounts, who do you think is the more intelligent modeler? Yardeni or Yellen? There are lots and lots of models out there. Any Ph.D. can build a model, but judgement is priceless and how you earn your keep.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.