Why do Most Computer Models Fail?
by Martin Armstrong, Armstrong Economics
Computer Models typically fail for the same reason why human forecasting from a gut personal perspective becomes a joke. In both cases, if there is no experience with the past, neither can possibly forecast the future. Such models have failed because they lack the historical database on a global scale. How is it possible to create a model that only goes back to 1971 where free data is available? What will happen is catastrophic. It will work for the period that everything is normal, but it cannot predict the major events like the Great Depression and Sovereign Debt Defaults for it has never seen such events in the data.
The models that resulted in the collapse of Russian bond debacle in the Long Term Capital Management in 1998 were created by brilliant men who had no trading experience. The book, When Genius Failed, went into the arrogance of the firm and the era. Long-Term’s partners relied upon what they though was the magic formula that could predict markets. Their arrogance in mathematical certainties created a new age culture of Wall Street that set the stage for its collapse, yet it has still not quite gone away. This arrogance remains and it has contributed to both the rise and the fall of Wall Street in search of the Perfect Trade.
When Long Term Capital Management (LTCM) was founded in 1993, it was touted as the most impressive hedge fund in history. Its mathematical models were blessed even by the Nobel Prize much like Obama was handed the Nobel Peace Prize simply for being the first black president. Yet in just 4.3 years, the wave of the ECM 1994.25 to 1998.55 had dazzled Wall Street as a $100 billion moneymaking juggernaut, I was personally told to join the “club” for with these mathematical models and Nobel Prize winning players combined with rigging the game and paying bribes to politicians, it was the Perfect Trade in Russia. I told them our model said it would collapse where their’s said the party would never end.
Long-Term Capital Management suddenly suffered catastrophic losses that jeopardized not only the biggest banks on Wall Street but the stability of the financial system itself. This resulted in the Federal Reserve, without any authority, bailing out a hedge fund for they would have taken down the high-flying banks who all bet on this Perfect Trade.
The dramatic story of Long-Term Capital Management’s fall illustrated that the Federal Reserve could have saved both Bear Stearns and Lehman Brothers but this was Wall Street’s payback. Bear refused to contribute money to bailout LTCM because they were not involved. Goldman Sachs’ Hank Paulson let them go because I believe they were competitors to Goldman and he wanted to steal their clients. There was plenty of precedent to bailout LTCM which was not a bank, so Paulson’s excuse was nonsense since the next day he rushed to bailout AIG that owed Goldman a fortune. Bush, in my opinion, was a fool manipulated by the people around him with their own personal agendas.
So the Black & Scholes Models failed for it lacked the historical depth to back-test the model under all conditions. This is why we spent so much money on creating a database all the way back. Even the model used for the CDOs, failed. David X. Li, the Canadian math wiz was blamed for that failure.
In truth, many people have tried to copy what we have accomplished tying together the fact we have used physics and then assume they can bring in math guys to create something they have no trading experience in doing. That has proven to be a wild ride to say the very least. It is the database that makes forecasting possible.
To put together this chart would cost over $100 million today. It was a major research project that was necessary to predict the future. The burning question was HOW DO EMPIRES FALL? Was it like a 747 plane coming down gradually for a landing, or was it a collapse out of the blue? If you do not spend this money, you cannot possibly predict how society will perform.
The 8.6 year frequency has been back-tested into ancient times. The discovery has been that amazingly it is part of everything that spans the centuries. This was like discovering the earth was round and not flat. Of course people will refuse to believe there is a business cycle and that cannot imagine that they will be compelled to act. What they fail to grasp is that the business cycle has always existed for it is partly influenced by nature, not just mankind.
There were people who refused to believe the earth was round for to them you would surely fall off if you were standing upside down. That was Issac Newton who had to discover gravity to explain that one. Today, there are people who cannot believe that something in the business cycle would be so precise. To comprehend what is going on and why, may take yet another discovery along the lines of gravity.
The database is the key. Without spending the money, you cannot even form the correct question. Hence, this has not been my theory of how the world should work, it has been my discovery of how it works and what remains now is to figure out why.