Wednesday, June 14, 2006

Princeton’s Global Model

Princeton’s Global Model

Since the dawn of time, man has tried desperately to predict the future. Man has gazed upon the stars, summoned soothsayers and astrologers and sought guidance in the patterns of tea leaves and chicken entrails. He has studied the movements of planets, comets, and even the flight of an owl. However, no matter what methods man has tried in his attempt to pull back the curtain, which stands between the present and his destiny, nothing has ever provided the infallible key to the future.
In this age of modern wisdom, where we look back upon our forefathers as being perhaps silly and superstitious, man has failed miserably in the so-called science of economics. It has often been said that economics is the only profession where one can be perpetually wrong in his theory yet still achieve world fame and the Nobel prize.
Far too often economists seek to change “what is” into what they believe “should be”, thereby reducing the science of economics to nothing more than a corrupt political social movement. It was, after all, the conflicting economic theories of Keynes and Marx that built the Berlin Wall. While Marx was correct in identifying the source of man’s booms and busts as human nature, his error was in believing that government officials were somehow so virtuous that they were above such petty temptations or corruptions.
At Princeton, we do not consult the stars nor do we believe in trying to change human nature. If a model cannot be built on “what is” then there is no point in creating something that will “never be.” We do not subscribe to a form of economic theory that advocates government control, but believe firmly that Adam Smith was correct in his observation of the “Invisible Hand.” Through years of our own observation and money management experience, we have come to see a much more dynamic Invisible Hand at work globally that still adheres to the core principles set forth by Smith in 1776. Understanding the nature of our global economy is not that difficult once we abandon unrealistic social dreams of creating utopia. The seemingly chaotic or random behavior of our economy is due to the enormous amount of complex variables involved that determine the final outcome. Our global economy is not unlike the dynamic system of the weather where the final outcome is caused by numerous combinations of variables. A small change in just one variable, such as water temperature in the Pacific, can result in dramatic changes within the overall global weather patterns.
Another example from nature can be seen in the work of ecologists’ studies of rain forests. Science has come to understand that man cannot create a rain forest by merely planting a group of trees. There are millions of species of bacteria and insects in addition to the thousands of plants and animals that interact to form a balance within nature. Man cannot duplicate a rain forest due to his lack of knowledge concerning such a wealth of intricate variables interacting with one another to produce the final balanced system.
Another problem for man in grasping a full understanding of market and economic behavior lies in his conscious thought process. In our natural state, our mind processes and records data in a nonlinear fashion. When we meet someone special, perhaps in a restaurant, our subconscious mind records the music and setting of the moment. It is quietly observing what the other person is wearing, the color of the table cloth, the flicker of candlelight, the background music and so on. Our conscious mind focuses on the conversation at hand. Months or even years later, if we hear that particular background music our mind suddenly retrieves the experience and consciously we relive the event right down to the twinkle of candlelight.

Economic and market behavior is quite similar to the operation of our mind. There are numerous variables hidden within the equation that determine the end result. Consciously we focus on only a small fraction of the variables involved. For example, we may pay a lot of attention to interest rates and stock market behavior or unemployment and its influence upon interest rates. We then try to interpret and make a judgment as to what the trend will be based upon just a handful of simplistic, fundamental relationships. Inevitably, such analysis proves to be incorrect due to the lack of attention paid to the wealth of other variables that will influence the final outcome. Normally, our subconscious mind would record these types of things for us in a social setting. Yet, in financial analysis we are ignoring the actual process of collecting knowledge by continually trying to reduce the entire fate of the world down to a few simplistic relationships such as interest rates, trade, corporate profits, or whatever.
We strive to develop a global model which filters in all key economic data along with free market movements that include everything from bonds and stocks to wheat and aluminum. The results, thus far, have given us perhaps the best track record of long-term economic forecasts on a consistent basis. Our overall model design takes into account 35 world economies and views the global trend as a sum of the parts.
In a study we published in 1986 entitled The Greatest Bull Market In History, a complete review of the world economy is given for the period of 1919 to 1946. Both the bull market and the great crash are covered in detail showing the precise interaction between all major commodities, stock and bond markets, foreign exchange, government decisions, corporate profits, unemployment and gross national product. By putting the global economy together, rather than attempting to forecast the fate of one market or economy in isolation, a new level of understanding emerges. For every action taken in Germany or France, a reaction takes place in all other nations ranging from subtle changes to major disruptions.
The global trends that are set in motion are the result of smaller trends emerging from every economy around the world. All nations strive for a trade surplus. However, it is impossible for one nation to enjoy a trade surplus unless someone else endures a trade deficit. Correspondingly, it is impossible for the entire world to experience prosperity simultaneously. One nation’s boom has often been another’s bust.
As a result of the two world wars, the United States emerged as the wealthiest nation on earth holding 76% of the free world’s gold reserves. As the countries of Europe fought each other, capital fled to the United States and created jobs and expanded its manufacturing base. However, as the US adopted a more socialistic philosophy by driving corporate taxes to 70% and the top personal income tax to 90% during the 1960s, capital fled offshore in a stampede. To this day, 60% of the US trade deficit is made up of US companies manufacturing their own goods offshore.
The trends in international capital movement are set in motion by the forces of taxation, inflation, geopolitical and financial security, foreign exchange, and the cost of labor. There are some additional minor influences, such as interest rate differentials. Nevertheless, capital is continually flowing from one economy to another in search of profit and/or financial stability. With the advent of floating exchange rates, this one factor above all others has become the primary source for volatility and capital flow movement. Price swings of 30-40% in the course of 1 to 2 years can wipe out normal profit margins and simple interest rate differentials.
Examples of the influence of foreign exchange can be extracted from virtually any commodity or stock market. If we look at gold we can see that the bull market moving into 1980 was a true bull market since gold made new highs in terms of every world currency. However, gold bottomed in 1985 in terms of dollars and rallied to $500 going into 1987 (Figure #1). While most proclaimed this to be a new bull market, gold was still declining in terms of most other currencies. In order to create a bull market, it takes solid buying support from all nations—not just one. If we look at the Dow Jones Industrials since 1915 expressed in Swiss francs (Figure #2), we can see that by 1991 we had only risen to re-test the true peak in this market established back in 1966. Capital has only begun to return since the tax structure in the United States was drastically reduced. The true definition of a bull market is a market that rises in ALL forms of currency, NOT just one. When expressed in terms of a basket of currencies gold peaked in 1986, not 1987 (Figure #3).

At Princeton, we have built global models by gathering together the world’s largest database of capital markets. Our computer models have every world currency back to 1900 with major currencies back to the 1700s. We have the most complete database of world stock markets, interest rates and commodities combined with most economic indicators. Using this immense foundation of data we have also built one of the few true Artificial Intelligence computer models. Unlike expert systems where man merely inserts his own rules, true Artificial Intelligence systems learn through experience. Our computer model has taken every individual variable and tracked it side by side with everything else in the global economy. Its forecasts are the result of history —not theory!
Man can only forecast what he believes is possible. If he has never experienced war, how can he possibly forecast war? The global approach to forecasting is the only hope we have of fully understanding the complex network of global interrelationships. For every fundamental that we believe moves the market, there is an example of the same fundamental producing the opposite result. Knowing when higher interest rates affect the stock market and when they do not, results from the external influences we may not be watching very closely.
For every up-trend there is always the inevitable downtrend. When the marketplace moves in the opposite direction of what everyone expects, it is not the markets that are wrong—it is our frail and inept interpretations. No one will ever be able to forecast the future based upon opinion. The only reasonable approach is an unbiased one that considers all the possibilities based upon research of “what is” rather than “what ought to be.”


Trend-Signals said...

Thanks for your posts.

How would you apply this model to current economic condition? What's your opinion.

R said...

The model forecast that commodity inflation would move up strongly into feb 2007 and possibly extend out into 2012, so far that is correct.

Don Walanchuk (da_cheif) is looking for dow 20,000 which is more inflation, as Armstrong said inflation is built into the system, the danger is that we get hyper-inflation and a meltdown in the bond markets eventually which is what Marty figured would happen..question is when.