Nobel Prize in Economic Sciences 2013: Trendspotting in asset markets
nobelprize.org
nobelprize.org
If one tests a simple rule, for example "buy when the shiller p/e ratio dips below 15 and sell when it hits 20" then indeed, you would have seen some fantastic results - most obviously in the aftermath of the 2008 financial crisis, when after adjusting for inflation and dividends, you could have bought the S&P500 in Feb 2009 for 887.12 and sold it again in December for 1202.03, realizing a 35% return after inflation).
However, you also would have had the patience and determination to ride out some extremely tough times - you'd be long stocks for the 1987 crash, and completely miss out on the pre-2000 tech bubble, for example). You'd also have to ride out some drawdown that would have wiped out 50% of your capital before the eventual recovery.
In fact, you'd only have placed six trades in about 125 years --
1. Buy in April 1882 and sell in 1898, realizing 2.62% annualized, inflation-adjusted return over 16 years.
2. Buy in March 1907 and sell in 1928, realizing 1.01% annualized and inflation-adjusted over 21 years.
3. Buy in Sept 1931 and sell in 1936, realizing 10.1% annualized over five years (this was a great trade, as you bought in the immediate aftermath of the 1929-1930 crash, and just before the recovery of the early 1930s)
4. Buy in Jan 1937 and sell in 1961, realizing 6.79% annualized over 24 years (another great trade, but you would have had to hold your position over the second world war, which included some terrifying drawdowns).
5. Buy in 1973 and sell in 1992, realizing 2% annualized over 19 years. Again, you'd have to suffer losing over half your capital before you eventually came out on top.
6. Buy in Feb 2009 and sell in December the same year, realizing a 35% return in less than a year (the single greatest trade in the strategy's history, perhaps indicating how thoroughly depressed markets were after the 2008 crash).
You seem to be ignoring dividends.
The S&P 500 gave a total return of 11% nominal and 4.5% real from the high point in 1973 to the low point in 1992. (Note: I only have monthly figures for the 1970s.)
SPXTR, Jan 31, 1973: 60.27
CPI-U, Jan 1973: 42.6
SPXTR, April 8, 1992: 457.16
CPI-U, April 1992: 139.5
Total nominal return: 457.16 / 60.27 = 7.59
Annual nominal return: 7.59 ^ (1/19) = 1.11
Total real return: 457.16 / 139.5 / 60.27 * 42.6 = 2.32
Annual real return = 2.32 ^ (1/19) = 1.045
Note: Taxes not included in the calculation. Alternative investments, such as bonds and money market funds, would've been taxed as well. You could've gotten tax-deferred compounding starting in 1975, when the Traditional IRA was created.
Data sources:
1. GlobalFinancialData.com for SPXTR, extended backwards. Not freely available.
2. Bureau of Labor Statistics for CPI-U. Their servers remain up during the government shutdown -- but no data is being updated. ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
I think a major flaw with the Shiller P/E is that there is no fundamental reason for choosing 10 years of earnings for the calculation. Why not 7, or 12? When events like 2008 happen, and earnings drop tremendously and temporarily, it puts a serious skew on the metric going forward (until that single year is no longer used in the calculation).
It is, however, a useful tool for "guesstimating" whether future stock markets returns will be above or below historical averages.
This is typically what economic "scientists" do, they find a formula that fits a lot of past data, then they publish it as science.
If they actually used it to make money, then it would be better, but that is almost never the case.
People who make money in the financial markets don't publish their winning formulas.
Why? For two reasons.
1) It probably isn't a hard rule or formula. It is probably a combination of factors that go into a decision that ultimately becomes a "gut feeling". Then, the best traders, usually get out if the trade doesn't work right away. This is because something unknown is acting on the trade, and since they have no idea what it is, they get out.
2) They want to use the formula to continue to make money, and since financial markets are very dynamic, they formula might not work if a bunch of people start using it.
The purpose of my comment isn't to say that using Shiller's P/E ratio is a good way to make money. In fact, I'm essentially saying the opposite - that while I think the research is good, it would be an inappropriate tool for most individual investors, because of the length of the required time horizon, and the length and magnitude of the drawdowns you'd have to endure.
As an aside, I believe that your criticisms of economics are misplaced. Certainly there is plenty of poor research and curve-fitting that gets published in journals of economics. But there are also extremely capable economists whose understanding of data-mining bias and overfitting is far in advance of yours or mine, and who are extremely careful when evaluating models using historical data.
Randomized controlled trials: http://m.newyorker.com/reporting/2010/05/17/100517fa_fact_pa...
http://www.youtube.com/watch?v=S3REdLZ8Xis&list=PLzfJcwakFwl...
http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf
Edit: I certainly wish Steve Keen would get the prize. He is the Keynes of our time. But man can only dream.
If you are a Taleb fan (or just curious), check out this critique of his work:
[0] http://quixoticfinance.com/tag/nassim-taleb/
[1] http://unpleasantfacts.com/falken-on-taleb
People who actually predicted the crisis
[2] http://www.amazon.com/Greatest-Trade-Ever-Behind-Scenes/dp/0...
[3] http://www.amazon.com/The-Big-Short-Doomsday-Machine/dp/0393...
Same here - if you read the piece (http://quixoticfinance.com/tag/nassim-taleb/) it exlains in detail how Taleb's claim to predicting the crisis is 100% off the mark (and the said thing is that he knows it, which makes him a poseur).
If you used a havy-tailed distribution (e.g. something from the stable family, which was suggested by Mandelbrot (1963) and Fama (1965)) and/or allowed for time-variability of moments and/or accounted for systemic risk you would see different prices of assets that better reflect that downside risk.
This is a prize given by the Central Bank of Sweden, not really an unbiased source. They have a clear agenda to propagate, and it is more about how to get more money for them for central planning than about economy.
It is indeed sponsored by Riksbanken but the ones who actually choose the 'winners' are The Royal Swedish Academy of Sciences.
>They have a clear agenda to propagate, and it is more about how to get more money for them for central planning than about economy.
Everyone has an agenda. And I don't think you understand how the Swedish Central Bank operates. Central planning has nothing to do about it. Last I checked their primary task was to maintain the inflation at ~2%.
The only people who care about the title of the prize are elitists who clearly miss the point of discussion. This is a prestigious prize in the field of economic research. I don't see it as more or less relevant because it's called "Nobel". But thanks for pointing this out in every Economic Nobel thread.
Now, please, explain to everyone here the biases of the Central Bank of Sweden. Is it because it's run by economists? Who else should be choosing the prize? Clearly unbiased people with minimal economic knowledge?
Maybe you could provide us with a refutation of the works of Messrs. Fama, Shiller and Hansen, rather than just waving your hand and dismissing the work of men, far more accomplished than yourself in the field, as the "propagation of an agenda".
Everything I've come across suggest that Alfred Nobel detested their ilk, and wouldn't want his name associated with the prize in any way, shape or form. That's why the title matters.
Economists, generally, don't use their models in the real world. And when they do, they lose billions of dollars.
See Myron Scholes. He did it twice.
Because his "science" was flawed.
It drives me crazy that these guys not only get awards, but influence government financial policy.
The current people who are the "top economists" in the world, are, generally, ill-fit to their jobs.
Their abilities to assess risk are horrible.
They are making the world a more dangerous place, not safer.
Economics is very complicated, much more complicated than most leading economists think.
I am talking about people heading the leading economic and financial institutions today.
They are dangerous because they are overly confident of their horrible "predictions".
"An observational science is a science where it is not possible to construct controlled experiments in the area under study. For example, in astronomy, it is not possible to create or manipulate stars or galaxies in order to observe what happens. Other examples of necessarily observational sciences include geology, paleontology, epidemiology, and much of the social sciences."
Astronomy and geology, on the hand, have theories that explain a larger set of observable behavior. Maybe you still have unknowns, like wtf is a quasar, but you can mostly point to any star or planet and have astronomy tell you how it works. If I pick a random human society and provide a brief description of it to a social scientist, my confidence that they will then accurately predict other facets of that society is pretty damn low.
Example climate science: Have two models, and see which one predicts the next decades better.
A controlled experiment in climate science/geophysics/etc would involve building two earths (or stars, in the case of astronomy), subjecting one to a treatment and using the other as a control.
Economists also attempt to test micro-economic principles through controlled, randomized experiments, similar to how psychology experiments are conducted.
According to whom?
Wikipedia: Science (from Latin scientia, meaning "knowledge) is a systematic enterprise that builds and organizes knowledge in the form of testable explanations and predictions about the universe.
More importantly: who cares?
Game. Set. Match.
i.e. controlled experiments.
> More importantly: who cares?
Anyone who's interested in the truth.
Explanations can be tested through careful observation of uncontrolled environments.
Obviously not the real thing, but interesting to note.
Otherwise, a lot of care is taken to identify causal relationships in economics (e.g. thorugh instrumenting explanatory variables).
I have a question, how many "Nobel Prize" winning economists does it take to lose billions of dollars in a hedge fund?
The answer: 2.
Why? Because economists are generally idiots and don't worry about "real world" applications. They just enjoy listening to themselves talk and win awards.
Edit: I just looked over the paper. They make no predictions about the future. They just say "it is possible to make longer term predictions."
Again, since they don't make any predictions, how can this be considered science?
That's the sort of inquisitive, open minded, intellectually curious, fact-based sort of approach to the world that I like to see on Hacker News.
Science means, reproducible, testable and predictable ideas.
Economists use curve fitting formulas on past data, then call it science.
And, worse, they defend each other. I have taught economics, worked at hedge fund and studied economics in college.
They work at banks and governments, then use "science" to justify stealing money from the people they are supposed to be helping.
What happened to all the economists after the recent world economic crisis?
They didn't lose their jobs. They weren't held responsible for their horrible risk-analysis.
So, yes, they are idiots.
You have a very narrow definition of science as well. If in X years penicillin stops working altogether because of anitbiotic resitant bacteria will you start calling biology/medicine not a science?!
Economics deals with an ever changing enviroment.
Yes, because of the huge influence of the leading economists have on the world today.
Economics, in general, is plagued by poor research, poor results, and bad logic.
They help shape fiscal, monetary and economic policy, yet make horrible risk assessments, horrible predictions and believe their own bullshit.
>Economics deals with an ever changing environment.
Economics is way more complicated than people will admit. How can you model 7 billion people interacting? It's impossible.
Yet, they give these charlatans huge salaries, awards, real power in government and don't hold them accountable.
The leading economists (with a couple exceptions) still don't admit they don't know anything and won't adjust their thinking.