Predictions - Chatham Financial

Creative Commons Attribution 2.0 Generic License  by  nandadevieast 

The 1970s was a decade when scientific knowledge really began to coalesce around the prediction of earthquakes. Predictions of major earthquakes in China, Russia and Los Angeles lent credibility to the burgeoning field and led to a ramping up of interest in the subject. But in the years that followed, increased scrutiny was paid to the data behind these predictions, and it was ultimately determined that in no case had the science behind the forecast been substantiated. In China, the same methodology used to predict a major quake in 1975 had completely missed an even larger quake the following year, which killed hundreds of thousands of people. The Russian report was deemed inconsistent and unsubstantiated and ultimately thrown out. Finally, the Los Angeles quake that scientists predicted with such certainty never materialized. In fact, in the years since, the closest scientists have come to accurately predicting an earthquake was in Parkfield, California in the 1980s. Scientists discovered a fault that demonstrated consistent earthquake patterns, riddled the area with data recording devices, crunched all of the numbers, made their prediction for a magnitude-6 earthquake by the year 1993, endorsed it with 95% certainty and waited. And waited. And kept right on waiting until their magnitude 6 earthquake finally came…on September 28th, 2004, 11 years late. To add insult to injury, further study of the data showed that this quake did not even share the same qualities as the reference quakes used to build the prediction. The ultimate diagnosis: the 2004 quake was a fluke. Now 10 years later, scientists are no closer to being able to predict an earthquake.

But what about financial markets? Surely there must be some model out there that can predict a bull from a bear? One such historical model attempts just this without looking to anything nearly as high-tech as a seismograph. This model, born of a study conducted by Barclays, looks no further than city skylines. In fact, it uses skyscraper construction as a predictor of economic downturn.

The basic premise is that the same conditions that promote construction of some of the world’s tallest buildings often precede, and possibly precipitate, bear markets. The thinking is that skyscraper booms are a sign of excess credit, spurred on by rising land prices and excessive optimism. After the buildup, the bubble bursts, often before construction is even complete. Here are a few of the most prominent examples:

– The Empire State Building, the Chrysler Building and 40 Wall Street. All three were unprecedented in scale at the time and completed between 1929 and 1931. The Great Depression cascaded onto the scene in October 1929.

– The New York World Trade Center Twin Towers and Chicago’s Sear’s Tower. Finished in 1972-1974, these towers were christened on the doorstep of the economic/oil crisis of the 1970s.

– Kuala Lumpur’s Petronas Towers. These massive twin towers were completed in 1997, the same year the Thai Baht collapsed, plunging East Asia into financial turmoil.

– Dubai’s Burj Khalifa. Currently the tallest building in the world, construction began in 2004, was completed in 2009 and the building opened in 2010. 2008 saw the onset of the Great Recession felt worldwide. In late 2009, the government of Dubai nearly went bankrupt and had to renegotiate the debt schedule that fueled the massive construction boom to avoid default.

While the Barclay’s model is a nice thought experiment, connecting dots in historical data is a far cry from predicting the future. But this model may well have the chance to prove its mettle. The Kingdom of Saudi Arabia has announced plans to build the Kingdom Tower, which, at one kilometer tall, would stand 20% taller than the Burj Khalifa. What conditions are fueling this endeavor? For starters, the Saudi economy expanded at its fastest pace in 5 quarters last year as crude prices surged in a country where 90% of revenue comes from oil sales. Gross Domestic Product was up 4.7% in 4Q last year, the oil industry grew 4.6% and mining and quarrying grew 5.1%. In addition to this growth, the Saudi government has been spending billions to add jobs and build homes after watching the turmoil in neighboring Arab countries. But amidst all of this growth, onlookers are quick to point out signs that perhaps the rising tide is unsustainable. For example, the Saudi King is turning 90 this summer and his heir apparent is 78. What will new Saudi leadership mean for their economy? There is also the concern that oil wealth spread amongst 30 million Saudis doesn’t go as far as it once did. The majority of the Saudi workforce occupies the public sector. If the tower is built, who will end up leasing it? The Kingdom itself? All of these questions loom large over the plans for this impressive building.

But the real question is, will the undertaking of the Kingdom Tower punctuate the bursting of a Saudi bubble? And if it does, will that be enough to convince market participants to rework their market strategy around what they see when they look up at a construction site on their way to work? Probably not. The skyscraper theory might offer interesting fodder for academic thought, but it certainly doesn’t give precise, reliable data to act upon. And until the perfect models materialize for earthquake prediction and economic fluctuation, those living near a fault line will continue to be grateful for sturdy doorframes, and those not interested in speculation will continue to be grateful for hedging.

So if you find yourself thinking you ought to restructure the building blocks of your risk management policy every time you pass by new construction on a nearby high-rise, consider giving Chatham a call to talk it through. Also, be sure to tune in this Wednesday, April 30th, for Part Two of our ongoing three-part webinar series on Interest Rate Hedging. This upcoming installment, Crafting a Meaningful and Effective Policy, is all about fitting those building blocks together to make sure your policy doesn’t come toppling down. See you there, or give us a call 610.925.3120 or email us.