I have just read this article by The Inflation Trader. I read all of his articles and find them both accurate and interesting. This latest article is about modeling.
I read here and listen to bank pundits and economists on CNBC and Bloomberg giving forecasts of the economy and even worse, for the markets, based on the bank's computer model. These models are based on a series of assumptions about financial behavior, that it seems will last forever. I am sure you have all been persuaded to buy or sell on the recommendations of Goldman Sachs or J.P. Morgan. Nearly all of their salesmen come out with the line "our computer model predicts that..." to be followed by a number that is enticing enough to get you to follow their recommendation.
When I started investing in 1982 there were no computer models. There were buy and sell recommendations based on economic analysis. You could then read the economic analysis and decide if you agreed or not. If you did, you would follow the recommendation. I remember on several occasions requesting the analysis from my then broker, Williams de Broe, before making my decision. They got quite huffy, but they sent the analysis and I was able to decide what to do.
Some people would call this progress, but not me. Computer models have so far not been able to accurately predict human behavior. I would be very interested to know if any company has ever done any research into the actual results of economic models to find out how often they are correct.
Technical analysis is correct approximately 60% of the time. Relying on Elliott wave analysis, Fibonacci retracements and all the other technical tools gives the investor an edge, as they will be correct more often than not. I am therefore a user of technical analysis to help me to identify good investment opportunities.
How often are computer models correct - is it 40%, 50%, 60% of the time (or any other figure). There is a very interesting but rather old read here, entitled "A skeptic's guide to computer modeling." I quote from the article:
The usefulness of models lies in the fact that they simplify reality, putting it into a form that we can comprehend. But a truly comprehensive model of a complete system would be just as complex as that system and just as inscrutable. The map is not the territory-and a map as detailed as the territory would be of no use (as well as being hard to fold).
The point is that to put the correct assumptions into the model you would have had to work out all the correct variables and put them into the model. There is nothing useful gained here. The model has not simplified the problem so that we can understand it. On economic modeling, the author comments:
Of course, to optimize, economic agents would need accurate information about the world. The required information would go beyond the current state of affairs; it also would include complete knowledge about available options and their consequences. In most econometric models, such knowledge is assumed to be freely available and accurately known.
There is no analysis of the record of computer models in the article. However this article suggests that computer modeling is almost wasted time. I quote from the article using research by John Carter:
"When you have to keep recalibrating a model, something is wrong with it," he says. "If you had to readjust the constant in Newton's law of gravity every time you got out of bed in the morning in order for it to agree with your scale, it wouldn't be much of a law. But in finance they just keep on recalibrating and pretending that the models work."
Recalibrating is changing the assumptions. This took me to the article 'the big mistake' from the Watson Institute. The big mistake, according to the article, is:
Assuming that human behavior is immutable will inevitably lead to errors in forecasting the future, no matter which kind of modeling you do. Physicists conduct replicable experiments to uncover fixed physical laws. A scientist measuring the speed of light in a vacuum, for example, would find the velocity the same in the US or Tahiti. If another scientist conducted a similarly accurate experiment in Russia, the test would produce the same result. On the other hand, relationships between cause and effect for individuals and human institutions are dependent on institutional, social, and economic context. Furthermore, these relationships change over time. A market researcher attempting to predict consumer acceptance for a new toothpaste would find that a market test in San Francisco would likely yield quite different results than in Tahiti, even though the speed of light remains the same in both places. In addition, if the same experiment had been conducted in the 1950s, the results would have presumably varied wildly from those of the current day.
My skepticism on economic modeling has grown even more! If models came with a set of assumptions, it would at least help in deciding if they were worth believing. However, I have never seen one described in this way. I cannot find any statistics on the success of computer modeling and would be interested in any research that the readers may know of.
Conclusion
In the Inflation Trader's article above, there is a model. He is clear in informing you that you should take it with a grain of salt. However, our reliance and belief in computer models seems to be growing. I would expect this is due to the fact that they are easy to formulate and difficult to argue with. They also give us a sense of security. if something as complex as a computer model is predicting the future, it is more likely to be correct than any of our conclusions. This just smacks of cheap analysis to me.
I would caution all investors to ignore all present economic models given by investment banks. The world is clearly not in a state of equilibrium at the moment, and this makes the results of any computer models even more dubious. In the present circumstances of a world that is so unsure, my decision has been to remain largely in cash and risk losing any potential gains. I now ignore all computer models (and recommendations based on their conclusions) of the economy and markets, and I recommend that you do the same. There is, and never has been, a good substitute for proper research, combined with technical knowledge.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
