The Economic Roots Of Beta Climates

May 30, 2009


Big Corporate Bias Hampers Blue Chip Economic Research Results

As I am typing this report, I am listening to a Bloomberg interview of Nouriel Roubini. The interviewer comments: "Mr. Roubini, many investors follow your economic research and then employ it to make investment decisions. What is your take on the recent equity rally? What does it say about the economy?"

There are two points that strike me about the Bloomberg interview, the first being that Mr. Roubini is an independent economist who has never been closely aligned with Wall Street. The second point is that the commentator is wise to ask about the linkage to the economy (economic factors and equity prices).

I discovered Mr. Roubini's dire economic forecasts in the spring of 2006, while doing research for my May 2006 article, Peak Risk, which identified acute and growing investment risks stemming from a credit bubble. Back then only independent sources like Mr. Roubini and Eric Janszen, the founder of, were providing fellow researchers with information about the credit bubble and the linkage between Wall Street (debt securitization) and Main Street (excessive housing/consumer debts).

Escape from Normalville, published in November 2006, was a follow-up to Peak Risk. The 1981 movie, "Escape from New York," depicted the dire consequences from not getting out of a city in social and moral decline (not true). The cult flick was a contrarian indicator -1981 was near the end of a secular bear market and the quality of life in New York City has improved dramatically since then.

My escape drama defined the risks stemming from the mass illusions rooted in excessive debt creation. Wall Street was abnormal. I saw tight credit spreads, low default rates, cheap credit and other factors seen in 2006 as being in the right fat tail of a huge normal distribution dating back to 1920. I also sensed that quants had transformed Wall Street into Normalville. Normalville was a new American town that included Main Street via a colossal housing bubble. Normalville is a metaphor for quantitative modeling risk, which enabled the initial 5% decline in home values to be the prick that burst the credit bubble.

Finding Leading Indicators To Fit Current Times

Figure 7 shows some factors that helped me to know that we should Escape from Normalville in 2006.


Figure 7. Stocks Prices Normally Are Independent Of Home Builder Sentiment (HMI)


Back then, I analyzed the relationship of economic growth and stock prices to homebuilders sentiment (HMI or housing), which is a very leading indicator. Like other indicators, HMI turned up during the first quarter (Q1) of 2009 from an all-time low reading of 8. It was 33 in 2006 when we first published Figure 4. HMI's mean since 1985 is near 52. Before conducting research on HMI, our hypothesis was that a bubble would distort the normal relationships between homes values, equity prices and economic growth.

The first column in Figure 7 lists factors that are compared to HMI's correlations during various periods. The base period is 1984-1994. Ten years is not a long period for confident statistical findings, so our results were cross-referenced with other studies that showed stock prices and home values with slightly negative correlations to economic growth (Real Gross Domestic Product or RGDP) while 12-month forward (12-MF) home values displayed positive correlations. Throughout most of history, one's home has offered diversification benefits for homeowners with stock portfolio (through their negative correlations).



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