As Shakespeare wrote in Henry VI, “The first thing we do, let’s kill all the lawyers.” Contrary to popular belief, the proposition wasn’t designed to restore sanity to commercial life; it was intended to eliminate those (lawyers) who might stand in the way of a contemplated revolution.
Economists as an Obstacle: The predominant economic forecasting model is the “dynamic stochastic general equilibrium" (“DSGE”) used by most economists and central banks, including our own Federal Reserve. The model assumes a general equilibrium from which prices are drawn and that there are rational agents affecting that equilibrium.
In the perfect world that would lead to minor fluctuations around the equilibrium. As a consequence, there would be no economic crises as the system assumes a self-correction component—kind of like an automatic flight landing system.
The test of any model is its ability to represent reality and in its highest and best use to predict economic conditions. There were few models and even fewer economists that predicted the depth and breadth of the recent financial crisis.
Irrational Agents Model: The alternative to the DSGE is the Agent-Based Models (‘ABMS”) that is more akin to a weather system forecasting model whereby there is an interaction of numerous elements (agents) with different attributes (opinions) colliding together to form not only pleasant weather but severe weather (crises). If the DSGE was used to predict weather most days would be partly cloudy with afternoon showers.
The Land of Confusion: In a WSJ article “The Markets Can’t All be Right” (8/510), Andy Brenner of Guggenheim Securities noted: equities are focused on better earnings, currencies on a weaker U.S. economy, crude on a stronger economy, bonds on deflation, and gold on inflation and instability.
They all can’t be right. This significant diversity of opinion is supportive of a behavior based model of economic activity and one that can lead to investor herding.
Bond Bubble? There is accumulating evidence that bond markets are getting to be what the housing markets use to be in the pre-prick bubble phase: It is commonly believed that fixed-income investments will not go down, there is massive “piling on” into bond funds and out of equities, and IBM’s uncanny historical ability to sell bonds at low interest rates prior to rates climbing.
Need for Conviction: If an investor believes bonds are peaking, there is the UltraShort20+ Year Treasury ProShares ETF (TBT) which will perform twice the inverse of the Barclays Capital 20+ Year U.S. Treasury Index. It has 4.5 billion in assets and trades on average 10 million shares a day.