IT’S THE MONEY, STUPID
July 8, 2005
a.k.a., everybody knows you can’t predict the future
July 11, 2005 - Since the prediction model does not include any emotional elements, the recent London bombing events may skew the current topping formation and cause the top to be later than predicted.
August 30, 2005 - The same applies due to the Katrina hurricane, or any other masstive unexpected and unpredictable event.
Inflation? Deflation? Stock market crash? Gold bull market? Housing bubble? (Insert your favorite here)
How about just cutting to the chase and showing a direct relationship between what the Fed is doing and what the Dow Jones Industrial Average is doing and will be doing for the next few months?!
More money than goods
Way back when I was first learning about investing and economics, it struck me that I didn’t know many of the basic terms and the dictionary became my close friend… and some people think I didn’t and still don’t get out enough too. But enough attempted humor.
The simplest and most usable definition of inflation is “more money than goods”. Sure, there are lots of other definitions out there like “higher prices” and very complex ones too, but “more money than goods” just plain works.
In a hypothetical very simple economy, if all the factories are producing 1000 widgets per year and the monetary authority is creating 1000 monetary units per year, then the cost of one widget is one monetary unit. If in the following year, the factories are still producing 1000 widgets but the government and/or monetary authority creates 2000 monetary units then the widget will cost two monetary units… and that’s inflation at its simplest and most basic level. If that definition doesn’t mostly work for you, don’t read any further. It’s important to truly understand it before proceeding.
Related to investment timing?
I didn’t know how well that definition could actually work until mid 2003 when working on how I could time my entry and exit points better, and on virtually any investment too. It doesn’t take rocket science to know that when a recession is occurring, the stock market isn’t a good place to make money for example, excluding shorting and specifically selected stocks of course. But what about predicting when an economy is about to go into a recession or when it might start to pull out of one, and what about those crazy short term jumps up and down that don’t seem to make any sense?
The whole process of building a predictive model for the Dow Jones Industrial Average started from being curious to see if the basic definition of inflation and deflation could be directly translated into predictions. As you can imagine, we're not going to give away the formulas and relationships that go into the predictive model below, but will say in general how it was done. We applied that basic inflation definition to it by locating all sorts of different goods and money data from many public sources. About 80% of it comes from the FRED database at the Federal Reserve site (http://research.stlouisfed.org/fred2/ ). Then we plugged all that data into a huge spreadsheet.
Next, by a long process of trial and error moderated by an economics education and common sense, plus adding different time lags and weights to the various numbers, we came up with the basic prediction. By weights, we mean that items like Bank Credit get a much higher weight than for example Currency since the amount of credit available is much more important to money growth than printed currency in circulation. By time lags, we mean that different types of money take differing amounts of time to get into the economy. For example again, tax refunds or Fed Open Market Operations1 get into the economy faster than changes in the money measure called M32.
Lastly, in order to modify the basic model to match a particular market, more research was done to locate factors that specifically affect that market and then they were added in. One example that's part of the set of stock market adjustments is program trading3 percentages ( http://www.nyse.com/Frameset.html?displayPage=/marketinfo/ProgramTrading.html ).
The resulting prediction
In a very real sense, it proves that a direct relationship does exist between what the Fed does and how the stock and other markets respond after the created money has gotten into the system. To those who point out, and correctly I might add, that most money and credit measures are not only mostly in a positive range but are still growing my answer is “of course” and “duh”. The model measures rates of changes and relationships, not absolute growth. It also indirectly measures rates of growth and shrinkage in derivates. In my opinion, most everyone who is aware of the issues with derivatives don’t take into account both their size (at least 4 times the size of the world stock markets) and their potential for shrinkage (with losses in hedge funds for example) when talking about future inflation.
Do note too that by virtue of the time lags built in, changes that are happening now will not be fully reflected in the market for many months.
Not the holy grail
Do note that like almost anything, not only is the model less than perfect but also eventually the current formulas will cease to work well due to definition, focus and other data changes at the Fed and other data sources. Then it’s back to the drawing board. It’s also missing any objective measure of fear. But it sure beats a coin flip, and has done extremely well so far. Frankly, I didn’t trust the model myself at the beginning, but after several months I was very pleasantly surprised by the accuracy of the resulting predictions and my investing performance.
So why am I sharing it? Many reasons… probably the biggest is that I’m just plain tired of seeing so many folk and friends get victimized by “the markets”. There’s also the incredibly poor understanding of the primary economic driving factor of all markets being relative money creation by the Fed and other central banks, plus an element of wanting to “pay it forward”. Besides, very few will actually take it to heart and use it… it’s too outrageous to predict market directions and turns many months in advance. It’s fine with me if you don’t believe it too. After all, everybody knows it can’t be done…
Web site: http://www.nowandfutures.com
1. Fed Open Market Operations – Broadly, the buying and selling of government securities, such as U.S. Treasury bonds, by the Federal Reserve Bank.
2. M3 – A very broad measure of total money in the economy issued by the Fed. It includes checking & savings accounts, cash, time deposits, money market funds, etc.
3. Program trading – Trading or investing or speculating done under control of a computer program. In 2005 so far for example, well over 50% of the trades done on the Dow Jones Industrial Average were executed by computer programs.