Looking at history and the long waves of demographics is a great and fine thing. It can tell you a heck of a lot. It’s frequently the case that history is driven by large, abstract, impersonal forces rather than singular decisive events. But…
…to start forecasting equity markets using these metrics is a perilous thing. And it’s becoming all the rage lately.
The problem with demographics as equity market forecasters is that, first, in order for you to be right, you might have to wait, you know, a generation or more. Also, even if you can shoehorn a theory to explain all, at best you only have a few good data points to support the correlation tied to equity markets. That’s not much to stake a +20 year forecast on.
Markets adapt, and long-term profits approach zero for high-speed trading. The winners are market participants, who benefit from higher liquidity and smaller bid/ask spreads. The part most folks miss about the flash crash is the market self-corrected as fast as it sank.
Regulator, Go Slow on Reining in High-Speed Trading: Algorithm-driven trading appears to be self-correcting. That’s good—the hyper-fast world needs it.
By now, folks have gleaned the Sandy storm won’t have as much economic impact as feared. On the Monday of the storm I saw figures speculating upward of $75 billion in damages. By Wednesday’s end it was knocked down to ~$15 billion, depending who you ask. But it’s clear widespread consensus overestimated by multiples.
Acts of God are often a case study in bad economics. Though, it’s probably not the calculations so much as the psychology of the matter: it’s far better in most folks’ minds to overestimate than underestimate. If you worry too much, no one will blame you. But if you worry too little, fingers will wag in your direction. (In my view, most economists could use a crash course in Bastiat and Broken Window Fallacies before publishing their guesstimates, too.)
Natural disasters have rarely or ever had lasting deleterious effects on capital markets. It’s quite a statement about the durability and plasticity of global capital markets that the NYSE along with US markets generally can be closed for two days and one could barely tell come Wednesday’s trading action. And yet people worry over and over about this stuff.
“Tail risk” is all the rage today. There are products and prophesies galore on this supposed new topic.
To my mind, most don’t understand what tail risk is. The point of tail risk is that you can’t predict it, and so you then hedge nebulously to guard against the seemingly improbable. So let’s be clear: euro dissolution is not tail risk, though many believe it is. If you, and the rest of the civilized earth believe the euro will die, and that’s widely discussed in all corners of the galaxy, then that’s not a tail risk. Tail risk has an ineffable/unpredictable feature to it. Otherwise, it’s just fear-sodden doom and gloom that you can buy insurance against, often chopping expected returns and raising portfolio costs.
I guess you could sort of define Lehman Brothers as a tail risk. Except that banks fail pretty darn often through history—investment bank failures are not “8 standard deviation events.” Sorry. I’ve seen a lot of banks fail and I’m relatively young.
Folks are chasing their tails all over the place tied to risk these days. Even if you do recognize tail risk as a real category, no event in the modern era has kept equity markets down for very long. Even 2008. Perpetually hedging against the ineffable has never been a great pathway to wealth, and still isn’t.
The only way to beat the markets long-term in investing is to be an iconoclast. Ray Bradbury was one of our finest, and most human, sci-fi writers. He was a great writer first, and a science fiction writer second. Much like Philip K Dick, Robert Heinlein, and Isaac Asimov, his visions of the future influenced thinkers for generations to come.
Ray Bradbury, Prolific Science Fiction Writer, Dies at 91 – Laura Tillman
Futurism in general is a fascinating topic for investors to grapple with. It’s fun and awe-inspiring to think distantly into the future about what could be. But note: most every long-range forecast ends up wrong, and markets only discount a couple years into the future at the very most. Futurism is big danger for investing sanity. So have fun with it, but don’t invest today on vague notions decades in the fore. Here are a few recent favorite futuristic tomes:
- Physics of the Future: How Science Will Shape Human Destiny and Our Daily Lives by the Year 2100 by Michio Kaku
- Abundance: The Future Is Better Than You Think by Peter H. Diamandis and Steven Kotler
- The Next 100 Years: A Forecast for the 21st Century by George Friedman
- The Singularity Is Near: When Humans Transcend Biology by Ray Kurzweil
Forget about this part for a moment:
Wall Street Hubris Caused Facebook Mess – Zachary Karabell, Daily Beast
Unless you actually bought shares on day one (and didn’t heed Ken Fisher’s classic advice: “IPO means It’s Probably Overpriced”), there are more interesting things to note about the FB offering.
It’s the first ever (that I can find, that also isn’t something exceptional like coming out from under government ownership) IPO debuting bigger than the weighted average market cap of global markets. This is truly amazing—a big cap growth company IPO! It beats Google, it even beats zingers like EDS back in the go-go days.
This speaks volumes about the likely shift in market leadership from small value to big growth and quality, which in my view probably goes on for some time as the bull market enters later phases.
One of the new, and more amusing, fears about the modern economy is that productivity gains in robotics and other technological marvels will make humans obsolete and the structural level of unemployment is headed higher. My fine friends at MarketMinder recently put out a nice piece on the subject:
By Fisher Investments Editorial Staff, 02/01/2012
As unemployment numbers have remained (predictably, as we’ve said) elevated in the recession’s wake, some have sought scapegoats. Seemingly popular is some version of “it’s technology’s fault,” which goes something like: Because of improved technology in [fill-in-the-blank] field, fewer workers are necessary to produce the same output, thereby displacing workers and actually contributing to an unemployment dilemma.” The other common strain is to blame cheap, foreign labor that can perform similar tasks to US laborers for significantly lower wages.
Both views, though, express a similar basic fear of societal progress and ignore the widespread benefits such progress redounds on all Americans regardless of income or profession. After all, consider just a few short years ago, only the very wealthy could afford computers at all, let alone tablets, smart phones, etc. with Internet connections. Now, they’re ubiquitous. Over time, productivity is a powerful force pushing prices down.
In our view, there’s little to fear from American manufacturing (and other industries) becoming increasingly productive over time. Making technology more broadly available at cheaper prices benefits not only Americans but the world. Hardly seems something to bemoan—rather, something to cheer amid continuing efforts to fight the scourge of global poverty.
My boss Ken Fisher has been a pioneer in a lot of things: behavioral finance, the investment advisory business, to name a few of the biggies. To me, his newest book is especially important: Markets Never Forget (But People Do): How Your Memory Is Costing You Money-and Why This Time Isn’t Different (Wiley, November 2011).
So much of the work in psychology and economics/investing talk about the mistakes people commonly make in abstract terms or with lab experiments. But Ken Fisher’s book does something different: it takes many important lessons about how our minds fail (particularly our memories), and puts them in the context of market history. In particular Ken Fisher focuses on how short our memories are, collectively—how so many things we think are unprecedented actually have ample and clear precedence in our past, we just fail to remember. Psychologists call it “myopia”, “biases”, “aversions”, and many sorts of other official-sounding technical definitions.
Forget the technical terms and focus on the reality. This is a key reason to study market history carefully—it prevents you from forming false idols and notions about things that didn’t really happen the way we (you, me) remember them. Ken Fisher’s book reminds us it’s not that we simply forget (we do), it’s that we misremember routinely—brains tend to remember details based on emotion, not rationality.
Here’s a bit from a recent interview with Ken Fisher on history and market forecasting:
Ken Fisher: History doesn’t repeat, not exactly. And the past cannot predict the future, but it is one good tool in determining if something is reasonable to expect. Investing is a probabilities game, not a certainties game. Nothing is certain in investing—all you can do is determine what a range of reasonable probabilities are.
In the same way, it’s not a possibilities game. It’s possible the world gets hit by an asteroid and destroys life as we know it, but the far greater probability is no such terrible thing happens.
You can’t develop a portfolio strategy around endless possibilities. You wouldn’t even get out of bed if you considered everything that could possibly happen. Instead, as I show in the book, you can use history as one tool for shaping reasonable probabilities. Then, you look at the world of economic, sentiment and political drivers to determine what’s most likely to happen—while always knowing you can be and will be wrong a lot.
For more information on Ken Fisher’s latest book, visit Wiley’s website.
According to the indisputable Wikipedia:
Reflexivity refers to circular relationships between cause and effect. A reflexive relationship is bidirectional with both the cause and the effect affecting one another in a situation that does not render both functions causes and effects. In sociology, reflexivity therefore comes to mean an act of self-reference where examination or action “bends back on”, refers to, and affects the entity instigating the action or examination. In this sense, it usually refers to the capacity of an individual agent to recognize forces of socialization and alter her or his place in the social structure.
This has long been George Soros’s way of viewing capital markets: a reflexive relationship between prices set on markets and the economy. He details all of this in his 1987 book—now considered a classic—the Alchemy of Finance. And, let me tell you, reflexologists seem to be everywhere now:
- Climate Of Fear Restrains Growth - John L. Chapman, Alhambra Partners
- Euro Banking Fear Feeds On Itself - Thomas and Schwartz , New York Times
- Obama’s Last Best Chance to Stop Downward Spiral - Tom DeFrank, NYDN
And this is just a smattering of what’s out there in the financial press currently. This is fine insofar as it goes: it’s logical and natural that both markets and the broader economy look to each other for signals. And it’s even a useful way of thinking about how certain trends can go on longer than most folks believe they should. But like all fine theoretical ideas, they can become overwrought.
The stretched out end logic of the reflexivity idea is what’s being bandied about today: that market signals are going to lead the economy into an inevitable, inexorable, death spiral.
Not only is this not true, it never has been. The stock market has pretty much always been a leading indicator for the economy, and basically never vice versa. Moreover, at some point or another every correction and every bull or bear market have reversed course, with the bulls winning over time in magnitude—that is, the death spiral notion is simply a figment of hyper-pessimistic views about the world right now.
I’ve always believed meteorology has been a good way to think about economic forecasting models. Simply, economists can, via statistical analysis, have some visibility on what might happen next, but the system (be it ecological or economical) is so vast and complex we just don’t have the models to know with precision what will happen, even in the immediate future. So, after the Irene panic over the weekend, we instead get headlines like ‘People assume we can predict everything’…; NYT: Experts Misjudged Structure and Next Move…; IRENE: A PERFECT STORM OF HYPE…, and so on. It’s not that the meteorologists did a bad job—they’re just limited in what they can do, and in a situation where lives are on the line they will err on the side of caution.
This is basically—almost precisely—how to think about economic forecasts. Are we headed for another recession? Maybe. My sense is probably not. But recent weak economic data don’t guarantee anything either way. Quarterly and monthly data especially is lumpy, and never moves in a straight line. So, you get a headline like this that surprised a lot of folks this week:
Statistical economic analysis in forecasting, even just a month ahead, is at this point a lot like meteorology—the system is too complex to predict with perfect accuracy.