Market Insights: On Predictions… and Being Wrong
Michael Carrico, CFP®,CRPC®, Wealth Manager
Happy New Year! I am glad to be back with you in 2023. The end of the year is all about reflection and the beginning of the year is all about looking forward. With that spirit in mind, today is a good day to think about looking ahead and what that means in finance.
“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.”
― Daniel Kahneman, Thinking, Fast and Slow
I love to listen to podcasts that explore how humans think we know things only to be proven fools by time. Yes, there are several of them. As I was listening to a recent episode of The Constant: A History of Getting Things Wrong, I thought of a quote from Warren Buffett. However, I already use too many of those in my writings here, so I found the one above from Daniel Kahneman. In full disclosure, I have not read Thinking Fast and Slow and do not know the context of the quote in the book. That is one more book to read this year. I hope that I don’t wildly misinterpret the meaning, but it seems a fitting description of the finance industry.
On any given day if the market makes a big move, you will see dozens of articles explaining why it happened. Those articles are never perfectly accurate since no one has all the information on ever more complicated, interconnected global markets. That said, we do a decent job of examining and understanding the mechanisms that led to a market move. This competency in explaining what has happened often leads us to believe that we can predict what will happen. Then we are once again proven fools by time. As Kahneman said, our understanding of the unpredictability of the future is undermined by how well we explained what has happened. So, if we understand why something happened in the past, why is predicting how those mechanisms will work in the future nigh impossible?
To quote an economics professor from my college days, “The only way for an economist to always be right is to make one prediction on Monday and the opposite prediction a few days later, then only point to whichever one was right.” That is not to say that forecasting is useless to investors. To some degree we must forecast to invest. We need to believe that we are investing in a thing of value and that said value will increase over time. As you have heard from me before, and will hear again, this has worked out for investors in the long run. Both stock and bond markets have been an effective store of value and generator of capital appreciation for investors in the past. They are likely to be going forward. The difficulty with prediction is (at least) two-fold. One issue is that we do not know every factor at play, nor how the interaction of those factors will play out. The other is the black swan events, often defined in finance as events that economic models could not predict.
Considering the first problem, no two periods of time are identical. With so many factors affecting the economy, it is rarely the case that every factor aligns in the same way in two different time periods. The US has dealt with rampaging inflation before in the 70s and 80s. There was also an energy crisis in the 1970s and the Fed was raising rates. There were wars and international conflicts. That all sounds remarkably like the socio-economic landscape of today. However, there are minor differences in each of these cases that ripple out into the economy in various ways. In the interest of time, we can examine, for instance, how the Russian invasion of Ukraine put pressure on the price of wheat globally and on the price of oil and natural gas in Europe in particular. The price of wheat did jump in the mid-70s but remained relatively stable in the late 70s and through the 80s. There are also major differences between then and now. There was not a global pandemic at the scale of COVID-19 in that era. In recent history the pandemic exacerbated supply shortages and labor shortages both of which contribute to inflation. For instance, the unemployment rate is significantly lower today than it was in the 70s and 80s. Below is an admittedly messy graph showing how those factors differ in the two time periods. And those are only four factors of a multitude we could examine.
Four Economic Factors: 1970s and 80s and Today
The point here is that both major and minor differences in the socio-economic landscape make the 70s and 80s an era full of useful lessons we can apply to the economic difficulties of today. However, it is not a perfect blueprint, and we find ourselves having to apply some novel thinking to that schematic to adjust for the new circumstances.
The COVID-19 pandemic is a good example of that second problem: the black swan event. While some virologists may have been concerned about an event like the COVID-19 pandemic occurring, it was not a significant part of public consciousness until it happened. Nor could those virologists have predicted exactly what virus we would face, when, and how severe it would be. We did not have such an event in our models and so those models failed to predict the effects of an unknown event. If you are particularly interested in learning more, The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb goes into exhaustive detail on black swan events in finance. For the purposes of this article, suffice it to say that black swan events make the practice of financial foretelling a particularly difficult one.
Standing at the starting line this year there are many predictions of what is to come. The Fed has already slowed the pace of rate hikes and may pause this year which would bring some relief to the fixed income markets. The labor market may start to weaken which could be a cause for some dovishness from the Fed, though the chance of a pivot to reducing rates seems unlikely in 2023. Inflation may continue to fall. Although there are differing opinions on this with Michael Burry warning of rate cuts and government stimulus in response to a recession creating a second spike of inflation as seen in the 70s and 80s. There are predictions of a mild global recession, of housing sector weakness due to a prohibitive cost of borrowing, of a European energy crisis, of markets turning around mid-year, and on and on. Some of these predictions are bound to be right and an equal or greater number are likely to be wrong. Again, we pay attention to all of this because it is important to investors. However, we could get news tomorrow that changes everything. This means the predictions of today could be moot tomorrow.
Here is the good news for individual investors investing for the long term: short-term predictions aren’t the most important factor. Sure, accurately predicting what will happen today, tomorrow, or next week is critical for day traders. That is part of what makes day trading a generally unprofitable endeavor for most who attempt it. Predicting the future is hard and unlikely to be done correctly on a consistent basis. However, for investors saving for life goals like retirement or college, the most important factors tend to be financial planning, appropriate asset allocation, portfolio diversification and the discipline to stick with a savings and investing strategy.
Whatever is to come this year, including those black swans, we will be here to help and keep you informed. Keep an eye out for our upcoming Winter Market Outlook for more details on the specific factors we’re tracking at the beginning of this year. I’ll leave you with a personal favorite graphic of the “biggest tail risk” as defined by the Bank of America Global Fund Managers Survey. It shows what fund managers globally were most concerned about in the economy over time. As this year begins and headlines gain prominence, remember, there has always been a risk and investing for the long term has remained profitable through all of them.
Biggest Tail Risks to the Economy