St Louis Fed President James Bullard has released a paper detailing a revised approach to economic forecasting. It’s a very smart way of looking at the world – read it here. Briefly, he is saying that the current way of viewing the world as converging to a single state is no longer useful and instead should be thought of as a set of possible regimes the economy could visit, with the regimes being generally persistent, requiring different monetary policy responses, and switches between regimes as not being forecastable. In his submission to the FOMCs quarterly economic projections, he declines to provide a forecast for the ‘Long Run’, as it is outside his model projection range. His low projection of the Fed Funds rate over the coming years reflects his view that the present regime has a low neutral real interest rate, a switch to a higher regime is unforecastable. If it were to happen, it would cause a change to many variables – policy would not reflect a gradual shift to a single state, but would have switched regimes.
This approach to forecasting was pioneered by James Hamilton. The math is pretty complex (lots of markov processes, etc.), but here is a simple way to look at it. Suppose we have two possible states in the world, the bull state and the bear state. The variable that determines the state is unobservable, and since you can’t see it, you can’t forecast it. Suppose in the bear state that the daily returns to an asset, like the stock market, are selected from a normal return distribution with a negative mean. Conversely, in the bull state, the mean is positive. If the state variable is pointing at bear, the trend will be down, if bull, the trend will be up. The trendiness of a market is determined by how likely we are to remain in the current state. For example, if the probability of jumping from one state to another is 5%, trends are more likely to persist than if the probability were 20%. What causes the state variable to jump is unknown, as Bullard describes.
Intuitively, a model of this type is very appealing. Rather than trying to guess where the world is heading, as in conventional forecasting, you accept the world as it is and wait for the changes, or shocks. Think about this for a moment – its early 2014, oil is around $100. Most analysts expect oil prices to be stable or perhaps rise as the economy recovers. Not one soul predicts the move to $30. It has huge ramifications. Credit implodes, currencies crater, the Fed must rethink policy, the stock market stalls. What we had was an exogenous shock, an unforecastable change in the state variable.
We have always thought about macro investing in a regime switching framework, that is, attempting to identify unobservable state variables and regime switches, and positioning portfolios for them. Regime switches happen reasonably infrequently, most of the time market prices move like smaller sine waves of supply and demand forces around an equilibrium state – a particular regime. If you look around and have the freedom to invest broadly though, a regime switch is playing out somewhere. To use a hockey metaphor, skating to where the puck is going to be is hard. In markets where you frequently don’t fully understand what is happening in the present, let alone the future, it is harder. Prices tend to see it first and move before the stories we tell have changed to reflect the new regime.
In a world modeled this way, trend following makes so much sense. It is, effectively, a heuristic model for the state variable. It can be really complex (100’s of PhDs poring over the data) or simple, like the MLM IndexTM. The long and short signals of a trend model are estimations of the state variable for the underlying asset. In reality the process of finding and adjusting to a new equilibrium is messy. It gets complicated by behavioral factors inherent in market cycles, as business models are built, and more importantly levered based on a set of equilibria that can rapidly shift. We think a simple process is less likely to be sensitive to the noise and changes in fashion, but they all end up in roughly the same place.