Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 18 March 2013 at 13:19 GMT

Can a butterfly in Brazil really cause a tornado in Texas?

Head of Equity Strategy / Saxo Bank

This post is about Nate Silver's book The Signal and the Noise (which I am currently reading with great pleasure) and chaos theory and how it relates to the dynamic between economics and equity markets. This blog will be a follow-up to my latest analysis on the S&P 500 highs that spurred some comments about the uselessness of economics in relation to financial markets.

Similarities between economics and the weather
In 1969, Edward Norton Lorenz, coined the term butterfly effect which later transformed into Does the flap of a butterfly's wings in Brazil set off a tornado in Texas as the title of a presentation in 1972. The idea is that certain systems are very sensitive to initial conditions so that a small change in one place in a deterministic nonlinear system can result in large final outcomes at a later stage. In Nate Silver's book, the example used is when Lorenz and his team are running different forecasts for the weather in Kansas and get totally different scenarios despite using the same model and data. Later, the team discovered that one technician hAD truncated the barometric pressure data in one corner of HIS grid so the data reading was 29.517 instead of 29.5168. This small difference in the starting point before running the weather model created big differences in the forecast. This is the butterfly effect.

In many regards the economy is similar to the weather. It is a very nonlinear and dynamic system that constantly changes through time and where cause and effect seems to change through time as well. You can easily get spurious relationships and one leading indicator may not be so in all business cycles. In short it is a mess and the fact that so few predicted the last recession is testimony to the paucity of our knowledge of the economic system. To muddle things up even more, what is a leading indicator at one point of the business cycle may be a lagging at another point. Consumer confidence and housing starts are obvious recent cases.

Equity markets: a leading or lagging indicator on the economy?
In his book, Nate Silver's discusses whether the Conference Board's leading indicator of the US economy is in fact leading or not. The book says that it was a poor gauge in the Great Recession of 2007-2009. You can argue that indeed it did predict a slowdown in the economy ahead of the actual start of the recession, but the model severely underestimated the depth of the downturn. This has also later led to some profound changes of the leading index's composition. Previously, the S&P 500 was a bigger component in the leading index but that has now been scaled down to 3.9 percent. So the S&P 500 is actually perceived to be a leading indicator on the US economy. Interesting given the recent rally. But is it always a leading indicator?

US recessions vs. S&P 500 6-month rolling drawdowns

The chart above shows all the recession in the US economy since 1960 versus the six-month rolling drawdown in the S&P 500. What is clear from this 52-year period is that the changes in S&P 500 give economic forecasters a lot of false positives. Since 1960 there have been six false positives defined as a 15 percent drawdown within the last six months; more specifically in 1962, 1966, 1987, 1998, 2002 and 2011. Six false positives are many false signals given we have only had eight recessions since 1960. To make things even worse, in some cases the S&P 500 peaked a few months before the recession started making is difficult to interpret a small decline from the highs as a signal of recession.

Given that equities are more a leading indicator on the economy than the other way around, it is close to being useless to use most economic indicators as arguments for where equities should trade. Changes in risk premium and specifically relative risk premium between asset classes may say much more about the future direction (in probabilistic terms) or level of equities.

Maybe it is because of the avoidance of mixing up economics and investing that Warren Buffett has been so successful. Other successful traders in equities such as Ed Thorp did not use economics as input but instead focused on statistical arbitrage.


fxtime fxtime
Interesting stuff and the prior article (and this) has ceratinly changed my perspective on economics and the markets et al.
Cyprustrader Cyprustrader
Very interesting and insightful!
Michel Andre Michel Andre
We are reading the same book :), very interesting indeed on several accounts.
BennyBomstaerk BennyBomstaerk
Michel I cannot see your portfolio on TradingFloor. Are you not the sharing kind?


The Saxo Bank Group entities each provide execution-only service and access to permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on or as a result of the use of the Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. When trading through your contracting Saxo Bank Group entity will be the counterparty to any trading entered into by you. does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of ourtrading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws. Please read our disclaimers:
- Notification on Non-Independent Invetment Research
- Full disclaimer

Check your inbox for a mail from us to fully activate your profile. No mail? Have us re-send your verification mail