Thursday, January 17, 2008

The power of prophesy

Prophesy has always been a central theme of most religions. At the heart of many religions is a messiah type figure, but the supporting cast always includes many prophets. The ability to see the future has always been the desire of not only religious prophets but people in business and their personal lives. We remember a few years ago a lady called Ms. Cleo, who used to televise psychic abilities on “expensive” television ads, indicating that there was a demand for that type of service.

Investing is no different, as investors pay investment managers to predict what will happen in the markets and consequently make successful investments on their behalf. We have seen also recently in Jamaica where prophesy has played a big part in our politics, as Prophet Phinn was a greater discussion point than the economic issues, and when that prophesy did not work out many reasons were given why it did not come true.

Such is the power of prophesy, and we all hold on to the desire to predict the future for financial and other gain. When making an investment, or predicting elections, the odds of success are 50-50, as the investment, or election, can go one way or the other. So in many instances a prophesy is nothing more than a gamble that something will happen one way or the other, and the reward for success is usually great, while the risk of loss can usually be tempered. For example when trading currency one can makes an informed bet that the market will move one way or the other, and if the prediction is successful then the reward can be exceptional.

Importance of data
The more successful prophets, however, usually base their predictions on sound data or trends. For example in Prophet Phinn’s case he was betting against the hard data (the polls) and a desire of the people to see change. The odds were therefore definitely not in his favour and anyone who bet on his success would have lost big, as the risk was always greater than the reward. The fact though is that usually if one properly analyzes the data then fairly accurate predictions can be made about what will happen in the future.

This ability to predict, based on data, is a feature that seems to be lacking in the Jamaican landscape. This I believe is one reason why we always seem to be caught by surprise with economic surprises, and seem to have been continuously in a state of economic decline. It seems as if we manage more based on emotions, and what we believe will happen, rather than taking a practical look at the data and interpreting what will happen. This is at the heart of the financial statement analysis that accountants are taught. But even many that are taught this art do not seem to have come to terms with it as yet.

Similarly I can’t understand why we have not been able to predict what is happening in the global market today. From as early as March 2007, I remember speaking with Ralston Hyman, and discussing the increasing probability of a US recession and increase in oil prices. There were many of course who were saying that the sub prime crisis would be contained, and there would be no spillover into the US economy, much less globally, just because the great (or not so great today) Ben Bernanke was saying so. I remember having the conversation with a young economist and he was adamant that Bernanke was correct, and we would not see any negative effects on the wider economy. Well my argument to him is that as an accountant we are trained to analyze data, and predict based on data, rather than just listen to the emotions of the market. In the short run it is emotions that move markets, but over the longer term all markets are influenced by fundamentals (data).

My basis for saying that the sub prime effects would spill over into the wider economy was based on logical reasoning, as I had discussed with Ralston at the time. The fact is that the US economy is 70% consumer spending. The fact also is that at the time we knew that many of the financial institutions had created derivatives (CDOs) from the sub prime mortgage instruments and sold them into the market, thus multiplying the effect into the financial system. Now if we accept these two facts, then wouldn’t it be obvious then that if the consumer and financial markets are affected then it would have a spill over effect in the wider economy. What was driving the US economy also was the boom in the housing market, so if this sector is affected then wouldn’t the growth in the economy be affected. It seemed logical to me but I am also trying to logically consider the argument on the other side without much success.

Oil warnings
The data, at that time, also showed that demand for oil was increasing and there was growing turmoil in the Middle East. At the time oil was below $60 per barrel, and the year before we saw a significant percentage increase in the price of oil. There was no indication that it was a short term bubble, as the growth in Asia, particularly China, was consuming everything in sight and there was no evidence of let up. Still we refused as a country to come to grips with what was happening and ignored the call for action. Even China was able to adapt, with all their strength, and today 60% of their energy generation is from coal. In Jamaica’s case though we have painted ourselves into the corner of an additional US$300 Million import bill, when we should have started to prepare for preventing this from 2006.

What I have found though is that if one makes an assessment that a negative is coming then you are not really taken seriously, as we do not like to hear bad news, even if it is logical. If one predicts, using emotion, that something positive will happen then everyone will accept it, as people love to hear good news. So it is a natural part of human nature. This was the case in the recent downturn in the US market also, where there were some commentators on CNBC who were saying for a while that the US is going into recession, and that a significant rate cut is needed. But most of the persons were saying that the decline in the stock market was just a healthy correction, and that the mortgage write offs last year was the last of it, even though the financial institutions admitted that they did not have a handle on the value.

So here we are today. As a country we have failed to take advantage of the record global growth levels over the past three years, and we are suffering because we have failed to prepare for the inevitable slow down in global growth (because economies move in cycles). So our inability to predict properly has caused us to have the worst of both worlds. What we must focus on though is going forward and stop this long term down trend in our economic fortunes.

With a globalized economy we must understand that the competitive edge comes not from just the natural advantages we have but the ability to stay one step ahead of the competition. What it means is that we have to develop the ability to predict what will happen, and take both the good and bad news, as not doing so will continue to be to our detriment. In making projections though it must be based on proper analysis, and not just the meaning, of the numbers.


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