Well, we go again. Another year, new resolutions, new goals or perhaps for some a preference to just drift and lament what ‘they would do different, if they only had the time, or the money’. Whatever your current situation or perception of the world, only you can change it for the better.
As for the global economy and financial markets, the outlook is as it always is. Uncertain, highly uncertain. Of course, the challenges and the opportunity set might be slightly different from last year, but ultimately with human decision making at the heart of the economy and markets, we can expect a range of possible outcomes at a macro and micro level.
The annual ritual across the big Wall Street investment firms is to release their predictions for the year ahead, for example what the closing value of the S&P 500 Index will be at the end of 2016. The results from last year show that almost all firms were overly bullish with their predictions, as were their revised predictions as the year progressed. This is not to denigrate the research they provide, I am just not convinced by the value of such predictions.
I have almost finished a very interesting book, “Superforecasting: The Art & Science of Prediction” by Philip Tetlock and Dan Gardner, which I would encourage you to read if you want to learn more about forecasting. As Tetlock and Gardner point out in the opening of their book, “We are all forecasters. When we think about changing jobs, getting married, buying a home, making an investment, launching a new product, or retiring, we decide based on how we expect the future will unfold. These expectations are forecasts.”
The authors share interesting insights on the workings of the brain that drives our decision making, how to appropriately evaluate decisions made, as well as a way of thinking that can improve your own judgment on how things will unfold in the future. Reading the book will also help you to see through the charlatans of this world, of which there are many in the financial services industry.
As I look ahead for the year I can see the same challenges that everyone else can – a deeper slowdown in the global economy led by China and the emerging markets, the fallout from the collapse in commodity prices, the repercussions across bond markets when liquidity is tested, the Fed’s efforts to normalise monetary policy and the impact of a stronger US dollar, how the central bank experiment ends, to name a few – but quantifying the impact and the timeline for when these risks might manifest into a more serious correction across the major equity and bond indices is a difficult task.
There is not a simple answer to ‘how will the markets perform in 2016’. There is a range of probable outcomes, ifs and buts, opportunities and risks, but certainty is a rare commodity as you move out the risk spectrum from short term cash deposits. The sometimes vague language used to convey how events might unfold can be a frustration for clients. Even when we use numbers to articulate the probability we have assigned to an outcome or expected return of an asset, confidence intervals, they can merely serve to cause confusion.
This challenge is not limited to predicting the performance of financial markets. Tetlock and Gardner give examples of where the US government misinterpreted the expected outcome of military action conveyed by the wording of a National Intelligence estimate. In 1961, President John F. Kennedy was told by his Joint Chiefs of Staff that the CIA led plan ‘to topple the Castro government by landing a small army of Cuban ex-patriates at the Bay of Pigs’ had a “fair chance” of succeeding. As we now know, it was a massive failure.
However, it later turned out that the author of those words said he had in his mind odds of 3 to 1 against success. As the authors point out, perhaps Kennedy’s thought process on whether to give the go ahead may have been different if the Chiefs had said “We feel it’s 3 to 1 the invasion will fail”.
Perturbed by this disconnect, Sherman Kent, one of the leading figures in US National Intelligence at the time, proposed adding percentage probability intervals to the wording, to better convey the likelihood of the event happening. It was never adopted, with a variety of reasons put forward. “Some expressed an aesthetic revulsion. Language has its own poetry, they felt, and it’s tacky to talk explicitly about numerical odds. It makes you sound like a bookie”, prompting the response from an ‘unimpressed’ Kent “I’d rather be a bookie than a goddam poet”.
However, one objection I thought relevant to our own use of probability intervals for expected returns was: “expressing a probability estimate with a number may imply to the reader that is an objective fact, not the subjective judgement it is”. The message, and one that resonates with my own beliefs on forecasting, “numbers, just like words, only express estimates – opinions – and nothing more”. As I share my own opinions on markets I’ll do my best to be a poetic bookie.
As you will be aware, my broad views on financial markets have been predominately driven by how I see market participants interpreting the monetary policy decisions of the major central banks. By this process, equity markets in Europe and Japan should benefit in the year ahead, relative to other developed market indices, as the European Central Bank and the Bank of Japan pursue more aggressive monetary policy. China’s Central Bank will also be one to watch, as they are called upon to assist in the smooth transition of the Chinese economy from investment led to consumption based. A tricky one!
I’ll be elaborating more on markets over the coming weeks but I think the first and most important step this New Year should be to define what you are looking to achieve. Over the years in working with private clients and corporate trustees, I have noticed that the tendency is always to put the emphasis on forecasted returns ahead of actually determining what the objectives are to begin with. Even when objectives are set they can often be too vague to add any real value. As well, they must be realistic.
Whether it is setting investment strategy for defined benefit schemes (DB), defined contribution schemes (DC) or individual clients, having a decision making framework in place can add some certainty to an uncertain world. For individuals in a private pension scheme, this is only one part of their overall wealth, and so it always advisable to make investment decisions for these accumulated funds in the context of an overall financial plan.
In setting your personal financial plan, do not make the mistake that most people do, and ignore what may be your greatest asset of all, human capital. Where financial capital is your accumulated monetary and physical assets minus liabilities, human capital is effectively your future earnings power. The type of job you have will dictate the safety of that human capital or the exponential upside and it can influence the risk you take with your financial capital. Think public service versus venture capital. This is something I’ll discuss in a future blog.
Either way, for many people, increasing the value of your human capital – through education, personal development, travel etc. – will be far more lucrative long term than fretting about where the S&P 500 will close at in 2016.
Bonne année, Vincent
January 3rd, 2016