- Economic forecasters have taken to quoting the "odds" of a recession, as if economic health were a game of chance.
- Economic futures are not based on chance—they're demonstrably cause and effect-linked.
- Ignoring bad metaphors like recession odds can make you a better investor.
Bad metaphors and poor uses of language lead to big market misperceptions. What seems like useless word-smithing can actually reveal a lot about sentiment and the way folks reason.
For example, many news services note when markets hit new all time highs. The primal reaction to such language is fear because, generally, heights are scary. Nevermind that markets have nothing to do with physical heights, or that an upward trending stock chart is a really good thing. The metaphor makes the emotion.
In speaking about the credit crisis, New York Times op-ed contributor Paul Krugman today said that in the past the "Fed has been able to wave its magic wand and make market turmoil disappear."
After the Money's Gone
Paul Krugman, The New York Times
Taken literally, of course, this is ridiculous—and most anyone can see that. But the contrast of ethereal hocus-pocus and Fed action is a very real cognitive reaction in our brains—Krugman wants us to compare magic and monetary policy. Don't do it! The Fed's monetary tools are effective and very real. David Copperfield is in no way involved, we assure you.
While we're on the subject, what about the credit "crisis?" Believe it or not, this one is a pretty good metaphor. Well, it would be if journalists stuck to the strict definition, which is "a turning point or decisive moment in events." In this sense, yes, we are probably in a moment where credit terms and lending practices are being reevaluated. Too bad most media outlets abuse the word and use it to mean disaster or breakdown.
Clearly, words matter for sentiment and perception. So you can imagine how it bugs us to no end when continually reading media claptrap about the "odds" of a recession. This is a terrible way to think about the future direction of an economy. Intuitively, there is an element of chance in that word—as if recession hinged upon a roll of the dice.
Goldman Sachs' Forecast: Recession Odds Increase
By Patti Domm, CNBC.com
But we don't see what chance has to do with the economy. Of course, we're not saying economies are determined by strictly linear, predictable events. But we do believe there are cause and effect relationships dictating where economies go. This isn't to say random events like natural disasters or terrorism aren't significant. But we get the distinct feeling that's not what most pundits are referring to when quoting recession odds.
Greenspan: Recession Odds Growing on Slowing Economy
By Staff, Reuters
Predicting recessions isn't like flipping a coin, where we can prove through some mathematical theorem the odds of the event are 50/50 each time. No, "odds" in the economics prediction game is a much looser metaphor akin to sports betting—where what the market believes is often way off the mark.
We have no doubt engineers and statisticians will be up in arms over such reductionist thinking about predictability. But we don't much care. Existing recession prediction models are far, far crazier:
Reckoning the Odds of Recession
April 10, 2006
Visualizing the Probability of Recession
June 08, 2006
The Yield Curve and Predicting Recessions
April 06, 2006
These theories aren't just wonky, they've been proven dead wrong. And note the dates of publication for these: Spring and Summer 2006—another time of high recession expectations that never materialized.
If you absolutely have to think about the economy as a chance event, we'd recommend using something market-based, like Intrade's prediction contracts (www.intrade.com). Their "Will there be a recession or not?" contract today says the odds are far less than 50%. But again, we'd strongly advise caution. An Intrade contract is not revealing the actual odds of a recession, it's simply telling us whether people think a recession will happen. Those are two very different things.
Don't let the jargon lead you astray; disciplined investing has no room for wordplay.
Have a great weekend.