InvestorPlace Blogs is powered by Marketocracy. Marketocracy has authorized Investor Place Blogs as an official registrar for voting through Marketocracy's Investment Research Rating service. Registered members of InvestorPlace Blogs are linked with a Marketocracy account to establish voting power based on their performance of trading and posting on stocks.
Sometimes a trader pays the price for not following the herd.
Case in point is my portfolio. If you are feeling blue about your portfolio returns, click on my portfolio to cheer up. I have been hammered over the past month as the market has recovered. The basics of my strategy have been to buy and hold and bet that we are at the beginning of a sustained bear market. My best case scenario is that I was a little too early in my analysis. My worst case scenario is that I am on a sinking ship with no one to bail water. However, I will not abandon ship at the first sign of trouble. After rising to number 19 in the rankings, I have plummeted way out of contention. At this point in time, ironically, the only thing that will save me is a stock market crash, something I wouldn't wish for even if it would make me a boatload of money and help me win the game.
As I look over some of the specifics of my trading strategy, the one I want to focus on is the Index of Leading Economic Indicators, also known as the LEI.* The LEI is an excellent tool, but with many flaws. The types of flaws inherent to the LEI also exist in many aspects of broad economic policy. These types of flaws have been addressed over the years, with Robert Lucas** (designer of the Lucas Critique) being just one of them.
We are all familiar with the disclaimer "Past performance does not guarantee future results" when it comes to investing. The same applies to broad economic policy, explained by the Lucas Critique.
The Lucas Critique says that basing monetary policy on historical data correlations is simple-minded because policy changes alter the rules of the game, making past data possibly misleading. An example of this is the past ideas of the negative correlation between inflation and unemployment. It was thought that as inflation went up, unemployment would go down, explained by the Phillips Curve. Stagflation of the '70's was the reality check. The Lucas Critique sought to give emphasis to modeling individual behavior and what individuals will do conditional on the change in policy. The fallacy of correlating inflation and unemployment were forewarned by economists, but to no avail. Some things never change.
In my own strategy, I have made trades based partially on the LEI, and Robert Lucas is laughing at me.
The LEI is an index that is designed to predict the economy's direction. It is published along with the Index of Coincident Indicators and the Index of Lagging Indicators. These Indexes are good answers to the questions "where are we, where have we been, and where are we going?" when referring to the economy. Just like all market predictors, it is not fool proof. The strength of the LEI is that it is based on economic numbers, not emotions. You can crunch the numbers, look at the trends, and make a decision. It almost seems too easy.
It isn't.
The weaknesses of the LEI are numerous. The most blatant is that out of the 10 numbers used to compile the Index, 3 must be estimated at the time of the release of the LEI. As a percentage of weight, 44.7% of the index is calculated with estimates, and those estimates can sometimes be wrong. A second weakness is revisions in the numbers after the Index has been released. Preliminary numbers are revised all the time, as we saw with the job loss of 4000 reported in September being revised up to an 89,000 jobs gain. A third weakness is that the LEI has a spotty track record in predicting recessions, and when it does predict a recession, it can be as close as 2 months away or as far as 20 months away. That isn't the type of thing day traders are looking for. The LEI released in September showed a decline of 9 of the 10 components, but the economy still looks strong. It isn't all bad for the LEI, though. The LEI does have a better track record at predicting economic recoveries. That isn't relevant right now, but the day will come, so keep the LEI in mind when that day arrives.
Until then, I will enjoy these sour grapes. Curses, Lucas.
*globalindicators.org/us/latestreleases
**http://nobelprize.org/nobel_prizes/economics/laureates/1995/press.html
| 
RSS 2.0
