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Sunday, December 6, 2009

Regarding Economic Debates and Opinions: The Fallacy of "Purely Objective" Analysis

No TA or FA in this post, just opinions. Which, as you will see, is the basis for all economic analysis. And I would like to confront this topic to show why any economic analysis (DCF modeling for a stock, relative currency valuations, M0,MZM,M1,M2,etc. trends and projections, TA, Elliott Wave Counts, even GAAP accounting) are all by their very nature subjective. That there is, in fact, no purely objective basis for any economic valuation

The Fallacy of "Purely Objective" Analysis

I am a Mechanical Engineer. I work in the Aerospace Industry. My main jobs are to perform thermal and structural analysis of aerospace vehicles. If anybody has a very grounded understanding of objective analysis methods, I believe I would qualify.

For a valid analysis or to make an analytical argument, you need indisputable facts:

F = ma, my'' + cy' + ky = F(t), Q = k*a*delta T, Q = emiss*Fij*sigma*A*(Ti^4-Tj^4), etc.

These provide a basis, under a wide range of conditions, to analyze a physical system to describe performance or to compare performance between to designs.

So engineering is a cut and dry analytical endeavor, right? .... WRONG! I am about to show that even in something as analytically based as engineering, there are still very subjective decisions that are made.

Here is a *very* simple example:

A part needs to transfer 30 Watts on a Spacecraft from an instrument to a heat sink. There are two designs: Design A gives a 10 C rise across the joint, Design B gives a 5 C rise across the joint.

Therefore Design B is better, right? .... Not necessarily.

Point 1) Lowering the operating temperature of a component is desirable in most designs - so B is better
2) Lowering the gradient across joints reduces the overall thermal distortion of a structure - so B is better
3) The part removes the heat by conduction. Conduction is proportional to Area. Area is proportional to mass, so in this case Part B weighs twice as much as A. On a spacecraft, mass is at a premium - so A is better
4) From a integration standpoint, larger parts typically reduce access to surrounding components - so A is better
5) Based on cost part B is more expensive (larger part / more raw material) - so A is better
etc., etc.

The point is, for any design all analytical decisions have a system impact, and some are very far reaching (mass, mass properties, cost, schedule, integration, etc.) and not all of these have the same weighting. In fact some are not even objectively based at all. What might be the "best" is often a compromise between a lot of disciplines. Sometimes leaving an inefficient part in the system is often the best choice if it is already designed, because redesigning a more efficient part leads to more overall work, cost and schedule.

There is no "Purely Objective" Analysis when it comes to any economic valuation

So I assert that valuations are subjective. And perhaps you don't agree, and you assert that there is an objective basis for valuing everything. Your assertion is also an opinion. At the end of the day, that is all this, or any discussion, is: a contest of opinions. Which I will demonstrate (hopefully successfully) in this post.

I have heard a lot of "well the only thing you are backing up your argument with is opinions". This is a true statement. However, the implied fallacy, is that there is some magical objective alternative argument. And I posit that it does not exist.

Lets first tackle GDP. GDP is an objective measure right? I mean a bunch of government economists pore over tons of data, they sum everything up, account for all the pluses and minuses and *voila!* you have GDP, right? ... Not so fast.

Hedonics and Substitution: There is something called the GDP "Deflator" in which the consumption part of the GDP is not fixed from year to year, rather it tracks habits (people can't afford sirloin so they switch to chuck roast, etc.). For another take on these, read this article. Hedonics is even worse, much worse in fact. It states "what is the value of the "quality" of improvements in the price of the product". So an economist massaging consumption data gets to say how much "quality" this product or class of products has on the population, and how that gets accounted for in consumption data? Does this strike you as an objective valuation tool? It sure doesn't to me.

Now couple this with the CPI. Most of the hedonics and substitutions that are negatively accounted for in the GDP Deflator are positively accounted for in the CPI! And not even necessarily in the same proportion! And I am sure I will get some flames from economist-types for the validity of this approach. But the bottom line is that this is a "judgment call" as to how much these improvements should be weighted. Which is by definition subjective.

Lets tackle something a little less controversial. Accounting practices.

I mean okay, the economy is big and complicated, but balancing the books for a company is clean cut, right? ... Not so fast.

For anybody who has looked at a balance sheet (and I have looked at many) there are are all kinds of ways that some transactions can be accounted for. Take "goodwill" and "intangible assets" for example. And many accounting sites already acknowledge these are Judgement calls

Let's further take the term Generally Accepted Accounting Principles. They are "Generally Accepted", except nobody generally accepts them!! Every company that reports earnings has a book worth of statements as to why GAAP accounting really doesn't reflect the nature of their business and they come up with non-GAAP reporting.

Again I ask you, does this sound purely objective?

The same thing can be applied to Technical Analysis and Elliott Wave Counts. Both TA and EW take patterns, support/resistance, trendlines from the past and try to project them out into the future. Is there any purely objective way to accomplish this? Patterns are unfolding and are by definition incomplete. The beginning of a patten could be bullish or it could be bearish. And it depends on an analyst's interpretation to say where the outcome will be bullish or bearish.

I have written so many rants along this line, that all analysis is an opinion, that I stopped writing it everytime and just started linking to it

Okay, I am dancing around the issue. Let me just come out and say it

Economic valuations are by their very nature subjective because of the fact that not everybody agrees what something is worth!!

Here is the best current example of this. Have you ever watched the HGTV show "Real Estate Intervention". Basically it shows homeowners trying to sell houses in the DC and surrounding areas in today's market. And it is an "intervention" because people need to sell, their house has been on the market for months, and they have a crisis.

And it inevitably boils down to Mike Aubrey (the real estate expert on the show) showing the homeowner in question the active and sold comps and explains why their house is overpriced for the market. And inevitably the retort back is something like "I am not going to give my house away" or "It is worth more than that"

.... wrong. A house is worth what the market will bear.

Same for stocks, bonds, gold, wheat, baseball card, CDSs, CDOs, etc.

Sometimes these have a seemingly straightforward basis for valuation. But I argue it is an illusion.

A house was a "sure investment" just a couple of years ago and now when people go to sell them, they are worth much less. Did we magically double the surface area in the United States in the last 4 years? And so now land is worth half?

No. It is because the biggest driver of what something is worth is not some impervious objective calculation. It is social mood.

Any analysis that does not take social mood into consideration is BS, as far as I am concerned.

This is what make opinions and nuanced observations of the economic climate and social mood so valuable in economic debates so useful. And it is what makes retorts such as "you are basing your argument solely on an opinion" completely worthless.

.... at least that is my opinion :)