Search This Blog

Friday, September 24, 2010

Anti-Periodic Events and the Lucas Critique in Relation to Timing a Financial Crisis

We have experienced a number of financial crisis. And I'm not just speaking of the events of the last three years. I'm speaking of ... well ... events that occur with regularity since the beginning of human economies.

Naturally, when ones speak and think of a financial crisis; they wish to know how to protect themselves. Which is only natural and reasonable. After all, one of the precepts I preach more than any other when it comes to investing and trading in the capital markets is ... what?

Risk control.

So ones reasonably wish to limit their risk when it comes to a financial crisis.

Unfortunately, this leads one to the idea of trying to time when the financial crisis will manifest itself onto the capital markets. They usually do so, because they measure large broad economic indicators and metrics. They will then point to a historical precedent where an crisis manifested itself with the same measure of economic metrics.

Which I believe, and most modern economists also believe ... is a mistake.

It is possible to identify when such bubbles are forming (i.e., the lack of wealth creative mechanisms on an asset class through two point deviations, fundamental anaylsis, etc). But trying to time when exactly such bubbles will burst, or when a financial crisis will manifest itself is nearly impossible.

The reason that these crisis are so difficult to time, is due to their anti-periodic nature of such Crisis', as well as the Lucas Critique.

What do I mean?

Well, let's first take the aspect that financial crisis are 'anti-periodic' in nature. Such crisis or events do not follow a predictable pattern in time. They do not occur at regular intervals. This is why I do not put much faith in 'technical timing tools' when it comes to the eruption of these larger economic problems onto the capital markets.

I cannot tell you the number of people that got their faces ripped off by trying to short an insane tech bubble, in 2000, because they thought they had the best timing tool. You cant 'time' when a bubble is about to burst, so it's generally best to stop trying.

But why? Why do such financial events not occur according to a predictable pattern and regular intervals in time? Why?

Because of the individual, and human intelligence, and that leads me to my second point.

Some folks, unfortunately, follow very old, and very outdated economic theories that do not allow for the flexibility of human intelligence. They are still working from the standpoint of the "Theory of Adaptive Expectations". Basically, and simply put, this theory states that economies will behave in the future based on what has happened in the past. In other words, if you study all of the large economic data and metrics in the past, that will tell you what is about to happen next.

This theory and concept is very outdated, and also very wrong.

It is advantageous to study historical patterns and LEI's that provide for some amount of metrics on a large basis for individual trades. I myself am a trader who uses seasonal metrics as a type of 'edge' when trading commodity futures. But there is a large difference between using seasonal metrics as an edge in the markets for a single trade, and using historical reactions to try to predict macro-economic outcomes.

In other words, the "Theory of Adaptive Expectations" means that folks will say "Well, in the past, this occurred given this measure of economic data, so with the same input, the same will occur in the future."

This is incorrect.

Robert Lucas Jr. proved some time ago with his "Theory of Rational Expectations" that individuals make decisions all available information that is current, rather than simply looking at past data. And that these individual decisions, when they build from a base, governs macro-economic outcomes. This theory proves that you must obtain a micro-economic foundation before coming up with a broad macro-economic thoughts regarding the future.

"[The Lucas Critique] argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data" - Robert Lucas Jr.

This has been proven repeatedly. Which is why I maintain that one of the strongest, and most important of economic indicators as of late? Is consumer loan demand. This is a measure of how individuals are behaving, as a group.

Regardless, returning to my original point ... the Lucas Critique teaches us that it is individuals who determine the outcome of macro-economic policies. Not the policy makers, nor the government. Nothing the government can do will change individual human behavior, or human decisions.

The government could offer to pay people to take loans, and if a group of individuals decides the government in question is not trustworthy, they won't take the deal. It is individuals ... not governments, that decide the outcome of economies.

Now we could sit and argue over efficient market ideals or the opposite thereof (the mention of Lucas will inevitably lead to that conversation). But that's not my point.

My point, is that it is individuals, not governments, that push a financial crisis to the world stage. This is why it is silly to try to time the eruption of a financial crisis. This is why financial crisis are anti-periodic in the first place.

* * *

Note: This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment adviser, or financial planner. But I do have 14 years of experience in trading and investing in these markets. The Challenge accounts are run for the education of other traders who should make their own decisions based off their own research, and tolerance for risk.

Search Investing and Trading Articles and Products