The pitfall of rock star economists

By Prieur du Plessis, on October 17th, 2011 posted in: Economy

Leave your comment

Print This Post

This post is a guest contribution by Dian Chu, market analyst, trader and author of the EconMatters blog.

The whole idea of going to University and studying Economics, replete with a thorough understanding of the importance of analyzing economic data points seems to be lost on these Rock Star Economists who dominate the financial media landscape these days. The only barometer these so called economists utilize is: “Oh, the stock market has been selling off hard for two weeks we must be in a recession”!

Here is an EconMatters’ quick overview on how markets work:

Investors/traders push markets up for as high as they will go, and then when they believe that the upside is pretty limited, then they sell, and shorts come in and piggy back on this selling, and both these factors serve to push markets down (this time as far down as they will go).

This occurs in markets quite regularly and when there is no long term impetus like a roaring economy, or an inflation generated asset program like QE2 in place, assets trade up and down in ranges, cycles if you will, as the business of trading takes place.

This trading volatility has very little to do with how the actual economy is performing, it is trading for the sake of trading. After all, markets could probably get by with only being open once a week, and four to six times a month ( a couple of days for important events) if it wasn`t for the business of trading.

Do you think markets need to be open 6 days a week practically 24 hours a day (with futures and currencies) from a strictly economic analysis standpoint? Well, they don`t, and this is where the whole business that has been built up around the financial markets comes into play.

The financial markets are big business, and economists need to recognize that market generated volatility needs to be largely disconnected from their analysis of the economy. It seems that some of these economists use the financial markets as their only indicator of economic health.

The reason this is problematic for economic analysis is obvious; however, the derivative fallout from this type of practice is equally troublesome. The scenario goes something like this:

Investors take profits, and selling occurs and the markets start going down, short sellers come in and add to the selling. In addition, the financial media reports a lot of negative stories on the economy and markets solely because the markets are going down. This scares more investors to sell, causing markets to go down even further. The cycle continues triggering additional program selling and portfolio stops along the way.

Financial markets continue to go down even further, and some funds are forced to liquidate positions they are perfectly happy with because of margin calls or portfolio losses in other areas. This self-fulfilling cycle of selling causes markets to go down even further, (this is why you often get markets to go directionally much higher or lower than an investor can ever imagine). All this Trading activity can and does occur on a regular basis and has absolutely nothing to do with the economy.
So if economists are looking at the stock market as a key indicator, and markets can fall a whole bunch with the economy being in the same exact condition when they were 25% higher, and economists were talking about ‘Green Shoots’! Then these economists are not only going to be mistaken in their analysis, but when they look at the falling markets, and publicly state that the economy is in a recession, the financial media love to interview them as “Credible Analysts” which only serves to further perpetuate the doom and gloom in the markets, causing an even greater distortion of the underlying economic reality.

The short sellers love this entire paradigm, it serves their purpose quite nicely, but it sure doesn`t help businesses who don`t understand the “Game of Financial Markets” to feel confident about the economy, and engage in robust hiring practices.

Businesses need Economists to be actual economists and be as objective as possible so that they can make business decisions based upon sound economic analysis, (it would be helpful if the financial media then Reported these economic facts), as a natural hedge or check and balance against the financial incentives of the strictly market based participants who are merely trading on volatility.

Here is how the scenario always ends:

All the profit taking has occurred, assets have been pushed down as far as they can go where Traders/Investors realize they can make a lot of money by buying right here, this forces the shorts to cover. Markets go on a nice rally, and then the economists all the sudden have a much brighter forecast for how the economy is performing, and where it is likely headed. The financial media chirps in with, “Gee maybe the economy is just growing slowly, instead of the End of the World Recession that we reported on last week!”

These cycles are ridiculous from an analysis standpoint, and this is where the role that economists are supposed to play comes into the picture and is much needed by businesses and even financial markets themselves, to cut through the media hype with an analysis of the underlying fundamentals of the economy, the actual economic data put in the overall proper context relative to other economic data sets, i.e., what is the trend, historical comparisons, important economic weights, etc.

Economists are supposed to be the rational, logical, analytical, objective source for how the economy is actually performing. What does the economic data say? How should businesses interpret the economic data? We realize it is much harder than just looking at the market activity for the past month and concluding that the economy is in a recession.

However, there is no value-added in that type of analysis, I can get that kind of information from a stockbroker or a cab driver for that matter. The academic rigor of economic research is what separates the economist and provides credibility versus the directional biased market pundit pushing a position. These days the differences between the two are becoming harder to discern in the age of Rock Star Economists.

In short, economists need to get back to being actual economists and not market directional cheerleaders; we have enough of those already in financial markets talking their respective books!

Source: Dian Chu, EconMatters, October 16, 2011.