Even if you had a crystal ball…

Everyone who works even remotely close to the investment management industry inevitably gets asked the question, “So what do you think is going to happen with the market?”  A cute answer that I’m sure I’ve used along the way is, “Well, my crystal ball has a crack in it at the moment.”  In other words, no one is a clairvoyant with market predictions.  I’ll go one step further though, even if you had a working crystal ball that could foresee significant events that could move the market, you still wouldn’t be any better off.

Many financial firms have complex models with dozens of inputs, all with the goal of predicting the behavior of some niche area of the capital markets.  The difficulty with this forward-looking process is that even if you get the majority of the inputs correct, you are still under your own assumption of how the market will react to each and every input.

Here are some examples over the last several years of how even the foreknowledge of significant events could have led you astray.

2016 Election

If there’s one thing the stock market abhors, it’s uncertainty.  When outcomes of various events don’t go according to plan, the market must recalibrate in order to adjust for different inputs that were  initially forecasted.  We saw this with Brexit when the polls in the U.K. turned out to be wrong.  We saw this when Lehman Brothers filed for the largest bankruptcy in U.S. history, despite A-rated credit ratings the morning of September 15, 2008.

Enter the 2016 Presidential election where  Donald Trump was widely regarded as the most unpredictable candidate of our time.  He was down in the polls and there was no way he was going to crack the blue wall.  Then, once the dust settled early Wednesday morning, candidate Trump became President-Elect Trump.  What was the market’s reaction to this uncertainty?  The day following the election the S&P 500 was up 1.1% and a cumulative 5% increase over the following month.  So, unless you were one of the small fraction of investors who were trading futures on the night of November 8th along with Carl Icahn, the only volatility you experienced was to the upside.

US Debt Downgrade

In August of 2011, Standard & Poor’s downgraded their credit rating of US sovereign debt, marking the first time in history that the US did not enjoy the AAA rating from all thee major credit rating agencies.  Bond pricing models have to account for many factors including maturity, liquidity, inflation and credit quality.  When credit quality decreases, (i.e. the chance of default increases) the bond issuer must compensate new investors with a higher yield.  When the US Treasury received a negative outlook in April of 2011 and the formal downgrade in August from S&P, one would’ve thought that the yield on treasuries would have increased.  Instead, this is what 2011 looked like:

The 10-Year US Treasury yield began the year at 3.4% and had a steady decline to end the year substantially lower at 1.9%.

Nuclear War on Social Media

January 3, 2018

Donald J. Trump(@realDonaldTrump)

“North Korean Leader Kim Jong Un just stated that the “Nuclear Button is on his desk at all times.” Will someone from his depleted and food starved regime please inform him that I too have a Nuclear Button, but it is a much bigger & more powerful one than his, and my Button works!”

This was one of my favorite tweets from our President.  As little as a couple years ago one might have expected that a flexing of nuclear muscles on social media would have created quite a commotion in the market.  I can find humor in it and discount the seriousness because the market has done the same.  How did equities react to this tweet?  The S&P 500 was up for the first 6 trading days of the year and 7.5% through the first 3 weeks of January – clearly traders were not pricing in a potential nuclear conflict on the Korean Peninsula.

Earnings

Earnings season tends to encourage water cooler talk around stock performance.  Sometimes the outcomes are confounding when a stock drops in value after the company reports better than expected earnings, revenue growth, and forward guidance.  We are left scratching our heads.  Perhaps analysts were looking for higher growth in a particular area of the company that they viewed as critical to long term sustainable growth (i.e. health care within GE, cloud services within MSFT).  Headlines are forced to come up with some kind of explanation – usually it’s something along the lines of “the expectations were already priced into the stock leading up to the report…” leaving yourself to ask, “what’s the point of analyst consensus earnings expectations then?”  True enough.

Federal Reserve Stimulus

I found this one most interesting.  If you knew in advance what the purchasing activity of treasuries looked like for the Federal Reserve during the 6-year period covering QE2 and QE3 (QE = Quantitative Easing), would that have given you an edge in the treasury market?  In the following chart I pulled the Fed Balance sheet info and overlaid that with the yield on the 10-year treasury.

FRED, Federal Reserve Bank of St. LouisSource: FRED, Federal Reserve Bank of St. Louis

Bonds 101 tells us that an increase in demand drives up the price of bonds, thereby decreasing the yield.  At first glance, the six-year picture does show an overall decrease in yield as the Federal Reserve purchased a trillion dollars’ worth of treasuries (roughly half the balance sheet is treasuries).  However, it gets more interesting when you look at the four distinct regimes of QE2, QE3, and the periods between and after, when the Fed was not purchasing assets.

Period Beginning Yield Ending Yield Change
QE2 2.50% 3.20% 0.70%
Between QE2 & QE3 3.20% 1.60% -1.60%
QE3 1.60% 2.30% 0.70%
Post-QE3 2.30% 1.50% -0.80%

You can see that during both periods of quantitative easing, yields actually increased.  Then in the periods where the Fed let off the gas (demand went down), yields decreased.  In a vacuum, this is the exact opposite of what you would expect.

But that’s my whole point; when it comes to capital markets, nothing ever happens in a vacuum.  There are always more inputs than you think, and the market reaction to those inputs is always more nuanced than expected.  Next time you catch yourself saying “if only I had known,” don’t sweat it.  It may not have helped you anyway.

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