There is a mostly unknown, subterranean battle of wills that takes place every day between high-profile economists who are paid to divine our future, often many months, or years, in advance, and “traders”, that is, financial market investors, who are reluctantly influenced by their analytical brethren.
I have lots of friends who fall into both camps. If there is one constant among traders, it is that they universally hate economists. The typical refrain is that economists (strategists and analysts too) are overpaid astrologists who could not hit a dart-board if it was pinned to their faces.
Economists, frankly, do not have much of a comeback to this criticism, since empirically they know, with some unstated sorrow, that their forecasting records over the long-run are, in truth, no better than the proverbial monkey pegging darts at a target.
Whenever I hear a trader lambast an economist, or the analyst fraternity at large, it has always irritated me, for reasons that I have not previously articulated. It was one of those subliminal push-backs that I get when a part of my brain knows something to be right or wrong, but has yet to thread the thoughts together as to why exactly, and comprehensibly, this might be the case.
These two cohorts do make for fascinating contrasts. As a group, economists and strategists tend to be detail-oriented, thorough, cerebral, well-behaved, and lucid, if not eloquent. Of course, you have some unavoidable genetic dispersion in terms of actual aptitude. Some are especially proficient at making a lot of noise and grabbing attention, but sadly fall short in the underlying horsepower stakes. Others have unusually impressive bandwidth, and would likely be successful at most things they turned their minds to.
The rarest breed of them all is the economist who would make, or has made, an outstanding trader. This is generally someone imbued with an unusual conjunction of qualities: bona fide intellect; the ability to quickly synthesise meaning from disparate information; and, most crucially, the capacity to make rapid, probability-weighted decisions. That is, someone with well-informed conviction. Oh and throw brass balls into the mix. You need to be able to accept and assume 'risk'.
What about traders? Well, pure traders, as opposed to traditional 'investors', are either gamblers or bookmakers. Gamblers never make money in the long-run. Bookmakers profit over and over again. A pure trader, like a market-maker, is imbued with an excellent intuitive sense for third-party (outside) sentiment, probabilities, timing and risk. Most importantly, they know how to correctly 'handicap' the likelihood of a distribution of future possibilities. They know when to parlay up their bets, and when to step away from the table because, for instance, the distribution is unknowable.
The single best test of a pure trader is longevity. If they have survived for a long time, say 10-20 years, with small losses (ie, draw-downs), and strong risk-adjusted returns (known as 'Sharpe Ratios'), they are likely the real deal.
The best natural traders are innate money-printing machines that have a tough time describing exactly why they consistently win. It is a gift, no different to that possessed by the serially successful athlete or entrepreneur. Sure, discipline is important to Harry Kewel, Roger Federer, or Richard Branson. Without exceptional discipline, traders die. But they need more than just this.
A good example of the instinctive kind of trader I am talking about is SAC Capital’s billionaire boss Stevie Cohen, who is profiled fulsomely in this Vanity Fair feature. For much of his career Stevie made most of his money by simply 'watching the tape'. He was able to subconsciously recognise patterns in real-time financial market data that few others could see. And by parsing this information, he was able to identify actionable decisions that generated predictably profitable trades. Paul Tudor Jones is another illustration of this reflexive personality type. If you want to watch Paul in action, check out this must-see documentary of him during his early days establishing Tudor.
A second type of trader is what I might call the 'hybrid': the analyst-cum-investor (I consider traders just another kind of investor). These are guys who were once strategists, economists, analysts or scientists (eg, George Soros, Richard Farleigh, Warren Buffett, or John Simons). They are deep thinkers, and voracious consumers of as much research and information as they can lay their hands on. Their edge comes not simply from screen-based pattern recognition, which is nonetheless a skill they ideally acquire, but from taking directional, or multi-directional “event risk”. That is, they are betting on a future outcome(s) that they believe to be inappropriately priced.
Many are known as 'global macro' hedge fund managers that concentrate on exploiting opportunities around regular economic, political and/or social events. Others are longer-term 'value' investors that tend to be low-frequency, and try, with varying success, to ride-out short-term market cycles and volatility until such a time as their assessment of an asset’s intrinsic worth is eventually accepted by the market.
A final band of brothers are the 'quants', who typically construct high-frequency, intraday trading models that aim to exploit market rhythms (ie, subtle relationships or patterns) that are not obvious to lay participants. They are the scientific iteration of the tape-reading Stevie Cohen. The single best exemplification of this cohort is arguably the world’s most successful hedge fund investor, Jim Simons,the founder of Renaissance Technologies. Simons, who taught mathematics at Harvard and MIT, and was the winner of the American Mathematical Society's Oswald Veblen Prize in Geometry, is estimated to be worth more than $10.6 billion.
My contention today is simply that the battle of wills between economists and traders is based on false foundations. For better or worse, market economists have a near-impossible task: they are forced to publish long-term projections about a range of tier-1 economic variables that nobody can claim to precisely predict.
The most well-equipped team of economists in our hemisphere – viz., the 100-plus analysts residing inside the Reserve Bank of Australia’s Martin Place office – have persuasively demonstrated that they cannot forecast two seemingly simple things – inflation and economic growth –with enough accuracy to base their monetary policy decisions on. They admit as much themselves. This is one reason why I have argued of late that the RBA’s November 2010 experiment with “pre-emptive” monetary policy has, for the time being, been set aside. Raising interest rates on the basis of projections that have limited reliability is an awfully difficult thing to rationalise. Much better to wait for the actual data to inform your decisions.
Nevertheless, the archetypal chief economist is asked to take a snapshot of the world today, and based exclusively on that cut of information, forecast what will happen in three, six, 12 and 18 months time. And then they are lampooned by traders when they get it wrong. As I have outlined here, such long-term guesses are a mug’s game. The world is far too complex a place to try to make a credible living by purporting to precisely quantify its dynamics in a distant state of nature.
The trader, by way of contrast, is not held to a specific image of time, or slice of data. No, the trader is able to flexible adjust his or her view of the world every single day, as new information and perspectives come to light. The best traders are well-known for doing exactly this. One often hears stories of how some celebrated trader expressed an opinion about a security or market in the morning, only to hold an opposing position later in the day. Of course, this makes sense. The world is continuously evolving. Life can sometimes feel like a sequence of completely unknowable, or utterly unforecastable, events that have been strung together like pearls on a necklace.
As I have observed before, nobody could have anticipated 2011’s incredible chain of crises. With the benefit of Harry Hindsight, it is easy to say that being “long bonds” was the obvious strategy to have put in place. Judging, however, from the returns of global macro investors, which, according to the Hedge Fund Research Index, are collectively down 3.3 per cent in 2011, this was easier said than done. All things being equal, these are meant to be conditions that macro investors thrive in: ie, volatile geo-political shocks. But there is only so much uncertainty that anyone can take.
Another way of making my point is this. If we asked traders to publish the same forecasts economists are required to release, I am confident that the results would be statistically indistinguishable. In fact, I would wager that economists would outperform their trading peers.
And this really is the crux: most traders do not make their money by being right over the medium- to long-term. It is simply too hard, and exposes them to too many exogenous risks. They make money by being right more often than not across a sequence of relatively small, short-term bets around how market prices react to current events. Sure, some possess a much more fundamental, structural, 12-month view of how things will pan out. But if all they ever did was punt this medium-term opinion, they would likely find producing consistent returns elusive.
The best traders are able to engage in ego-free mental gymnastics that permit them to profit in all environments – irrespective of whether those conditions conform to what they think should or will happen over the horizon. That is, they have a lot of intellectual humility. They don't mind being wrong.
Economists, on the other hand, are not permitted the same flexibility. This is highlighted through a simple comparison of the financial markets’ pricing of future interest rate changes relative to economist forecasts. The fact is that economists only irregularly change their views, and are inherently reluctant to do so. It is a pain having to explain to the world why in, say, December 2010 you were expecting one rate hike a quarter in 2011 whereas today you are calling for four rate cuts. In contrast, the financial markets’ expectations of what the Reserve Bank is going to do swing about wildly every day.
One economist friend of mine, who is an avid punter, loves nothing more than making big calls a month or more out from an RBA decision. He sometimes solicits my thoughts on these claims. I have tried to explain to him that he’s on a hiding to nothing.
Even within close proximity to the next RBA board meeting, bold predictions have a decent chance of being wrong. And this is simply because the RBA itself cannot say with certainty what it will be doing at the next Board meeting 30 days out from the caucus.
In August this year the RBA would have hiked were it not for the sudden intervention of the US debt ceiling crisis. By November they had resolved the contestable decision to cut. Will they follow-up with another cut in December? I did not think they would cut in October, but gave a 70 per cent probability to one in November.
Since November I have felt a December cut was unlikely. That belief has been reinforced by both recent RBA rhetoric and the data flows (eg, unemployment). But like the RBA itself, I will not have a firm view until a few days before the meeting, and this will presuppose no highly disruptive event risk interfering with the probabilities between that date and the Tuesday morning on which the five or six independent doves and the handful of RBA hawks actually gather.
It would be like me asking you to call the winner of the Melbourne Cup months before the race; when you have no idea what condition the track is in, and what the form of the ponies and/or their jockeys has been like.
The bottom-line: economists add an enormous amount of value to our understanding of the way in which the world has worked in the past. I reckon you dismiss their analysis at your peril. But it is a false dichotomy to try and compare the decision-making success of economists and traders.
Good traders are making probability-weighted guesses about how market pricing will respond to a distribution of prospective events. Economists, on the other hand, are trying to do two completely different things.
First, they are seeking to predict what specific event within the trader’s distribution will materialise. This is very hard, and why I have previously advocated economists attaching confidence intervals to their projections so that users understand the uncertainty associated with them.
Second, they are engaged in the arguably impossible task of trying to predict exact events over the long-term. No person in human history has been able to do that with verifiable reliability.
Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice.
This article originally appeared on Business Spectator.
Christopher Joye 
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