It's tough to make predictions, especially about the future.
It’s that time of year when those in the finance world make (and others read) predictions regarding the capital markets for the upcoming year. Macroeconomic factors such as GDP, interest rates, stock markets, commodity prices, and of course one thing that impacts all markets – the credit cycle – are expounded upon ad nauseam. Are we in the 6th inning of the credit cycle? The 8th? Extra innings? Is it even possible to know?
Consistently predicting credit cycle turns and other macro-economic data is a challenging exercise. Stories over the last few years of hedge fund managers being carried out on gurneys for errant macro calls are abundant. As long-only managers, there is no doubt that an understanding of growth expectations and an awareness of various dynamics at play in the markets are important when allocating capital among asset classes. We believe that a disciplined capital allocation strategy paired with a rigorous and repeatable investment process that manages risk throughout the cycle is meaningfully more important for generating long-term returns than consistently trying to make accurate macro-economic calls.
People like stories. We like our world to be predictable and explainable. It has always been this way whether humans have used stories of Zeus and Athena to explain their world, heeded the wise words of shamans, interpreted the entrails of animals, or read the minutes of a Federal Reserve meeting. Almost all daily moves in stock prices are noise, yet business news anchors will begin every evening’s news segment with “Stocks dropped today because…” or “Interest rates rose on news of…”. That is rarely the case, yet we are comforted by this false narrative, and in this yearning towards certainty we find ourselves pulled toward “expert” opinion. I think we should resist this inclination.
Why? Because the historical record of forecasts in finance is abysmal. Let’s consider a few examples from the recent past:
1. Oil Prices
In 2012, Wall Street commodity strategists were asked for their 3-year ahead forecast for Brent oil price. Goldman Sachs compiled all the forecasts. These forecasts consisted of detailed analysis of oil fundamentals, geopolitical scenarios, and utilized sophisticated modeling. Most predictions called for oil to be over $100 a barrel (bbl) with the majority of forecasts in the $110-$135/bbl range. How did those predictions fare? Fast-forward three years, in 2015, and we find that Brent oil averaged a measly $53.60/bbl (and got below $40/bbl), less than ½ of most predictions, as U.S. shale production expanded and helped lead to a global oil inventory glut.
2. Interest Rates
More PhD brain power probably goes into predicting interest rates than any other economic activity in the world. However, I am not aware if there’s been an economic forecast since the Great Recession that has been more consensus – and more wrong – than that of forecasting higher rates. The graph below is almost comedic in its errors:
As the lines show, actual rates (red line) rarely followed the forecasts (black lines). In fact, at nearly every point in time over the past decade, economic experts have forecasted much higher rates, a prediction that has not come to pass. This trend continues to this day.
3. Debt to GDP
Nations typically got into fiscal trouble when debt/GDP got above 100%, until Japan went north of 200% without major problems and created the “widowmaker” trade for investors.1 An article from Business Insider in 2012 highlighted that sophisticated investors are re-upping that trade.2 With the Japanese 10-year yield below 1.00% at that time, it might have seemed like a no-brainer…until yields went negative a few years later.
4. Asset Prices
Alan Greenspan made his famous “Irrational Exuberance” speech in December of 1996, noting his concern for potentially overvalued asset prices.3 Many Fed governors noted similar fears, and many smart investors agreed. Markets around the world temporarily sold off in the wake of those comments. But what it actually marked was the middle of that cycle, as the S&P 500 would rise 90% over the next 3 years and the NASDAQ would ultimately rise 300% further before crashing.
5. Home Prices
Ben Bernanke and the Federal Reserve noted that U.S. home prices had never declined before, and implied they never would. He proclaimed optimism on the housing market and economy well into 2007, the dawn of the most vicious financial crisis since the Great Depression.4 In October of 2007, the New York Federal Reserve officially predicted 2008 GDP growth of 2.6%. The Great Recession would officially start two months later.
Erroneous predictions are not just limited to the economy and markets:
- In Philip Tetlock’s book Expert Political Judgement, he analyzed over 80,000 political predictions espoused by so-called “experts” over two decades. How well did they fare? Poorly. The experts did about as well as chance, and the more in-demand the expert the less accurate their predictions were.
- In a more recent example, let us not forget that a Hillary Clinton landslide victory was all but assured in the 2016 U.S. Presidential election. The experts told us so. But what would happen to the stock market should Donald Trump win? Wall Street strategists, hedge fund managers, and CNBC commentators were unanimous that it would be disastrous. There are a plethora of articles to link to, but an CNN Money article read “A Trump Win Would Sink Stocks”.5 Not “might” sink stocks or “could” sink stocks. Would. Such certainty. The S&P 500 is up more than 30% since Election Day.
If these predictions serve one purpose, it is that perhaps we are able to see where consensus opinion lies, and we may be able to find good relative value going elsewhere. In chess, consider that just three moves into a match there are 9 million potential outcomes for three additional moves ahead. Four moves ahead there are billions of potential outcomes. Given the number of variables in the global economy, we must acknowledge the enormous uncertainty and biases in these forecasts and recognize them as not much more than glorified guesses.
All that is a long way of saying we should not base our investment decisions primarily on our predictions for interest rates, how many times we think the Federal Reserve will hike, where we think certain commodity prices will be, or when we believe the credit cycle may end. It’s a more appropriate exercise to develop a consistent capital allocation philosophy and then execute on a sound, repeatable investment process based on an understanding of the ever-changing risk-return relationship offered within the capital markets.
Continue reading about how investors consider the corporate credit cycle and why predicting credit cycle turns is a challenging exercise.
1 See Alan Gula, “Japan’s Infamous Widowmaker Trade,” Timothy Sykes’ Penny Stock Millionaires, April 25, 2016.
2 See Joe Weisenthal, “Hedge Funds: The Japanese ‘Widowmaker’ Trade is finally going to Work,” Business Insider, December 1, 2012.
3 Remarks given at the 1996 American Enterprise Institute by former Federal Reserve Board Chairman Alan Greenspan.
4 Series of interviews with Ben Bernanke on CNBC from July 2005, November 2006, February 2007, and July 2007.
5 See Heather Long, “A Trump win would sink stocks. What about Clinton,” CNN Money, October 24, 2016.
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