Knowing what you don't know is important

The chart above is from Morgan Stanley and does a great job of converting the famous Donald Rumsfeld "known knowns" speech into a simple investment matrix for decisions. The matrix is a good way to look at different market situations when there are different levels of knowledge among investors. 

In the case of the "known knowns", all information will be included in prices. No surprises here. It has already been discounted. Known unknowns are where you may have a competitive advantage relative to others in the market. You know something, but others may not know it. Unknown knowns are when you may be in the dark and others have an information advantage. You don't want to trade in this situation. Of course, the cases of "unknown unknowns" are when we are all blind to possibilities. We are likely in this scenario with the war in Ukraine.

A good employment print but headwinds are strong

Forget the employment number and focus on what is going on in the real economy. The world is changing so fast, that the employment data are backward-looking and not providing a strong indicator as to what the economy will be like over the next month. The following are a list of issues from the latest manager PMI survey, and this is not really accounting for more Ukraine war fallout.

• Energy price shock - over $100 oil and little reason to see this falling in the near-term. 
• General commodity price shock - metals and grains all higher which will put pressure on global growth.
• Logistical challenges - Significant backwardation in commodities and as fuel costs increase, shipping will be more expensive. Fertilizer is expensive for farmers.
• Supply chain disruptions - the supposed driver of transitory inflation has not been solved.
• Capacity constraints, shortages, and restocking issues - there are stock-out problems and limits on the ability to produce from continued supply chain issues. Production will not keep-up with demand. 
• Labor and staffing shortages - labor participation is higher, and unemployment moved to 3.8% but there is still an overhang of unfilled jobs. 
• Inflation - Continues to move higher and unlikely to reverse given the commodity price increases.

The stagflation story that did not take hold during the COVID pandemic has a higher probability of occurring. Using the NY Fed probability measure, the likelihood was only 6% for their most recent update, but current calculations will put that number at double that level.

Commodity oil supply shocks and recessions

 

When commodity price have rising and this volatile, there has been a recession. This type of up moves in commodities has not been seen in more than 45 years. While overall commodity prices are higher, oil price shocks, the main driver of commodity indices, have often preceded recessions. 

Just looking at oil prices suggest a high likelihood of recession, (see "The role of oil price shocks in causing US recessions") Of course, there has to be disentangling between demand and supply shocks and correlation issues versus causality, but the current run in prices over the last month are supply related and not driven by demand.

There was an oil price shock before the Ukraine War, 20+% in 2021 and 45% in 2022. A good portion of that pre-war increase was demand driven. Nevertheless, when we say supply shock, we should be precise. There is a logistics problem. Many buyers do not want to purchase Russia oil and it is selling at a discount. There is a supply disruption in the normal market logistics. There is also an uncertainty problem. The threat of future disruptions is leading to the desire to build inventories, a precautionary motive for holding oil.  

The overall impact is prices are elevated and they will not go down significantly even if there is a slowing of demand from a rise in interest rates from the Fed. Changes in US energy policy will not solve the short-term supply problem either. Businesses will have to live with higher energy costs. 

More information does not lead to improved accuracy

Must have more data! Need to increase my information edge! This is usually the cry of any analysts because, of course, more data and information are better than less data. If I have one more piece of data, I can solve the puzzle of what will happen next. In reality, the issue of marginal increases in information is more complex. 

It has been found that more information does not lead to improved accuracy. Accuracy remains stable as the amount of information increases; however, the level of confidence increases with more information. My forecast does not become better, but I feel more confident that it is true. This has important investment implications because our sizing of positions is often driven by confidence. We will likely take bigger bets although our chance of being right may be the same. This does not mean those are better bets.

The overconfidence bias is real although more works needs to be done to determine under what conditions it will occur. In highly uncertain environments, does more information improve accuracy and is increased confidence good.  Overconfidence is tied with other biases. As we add more information, we are likely to further confirm our opinions and not look for information to contradict our views. 

This bias does not argue for ignorance, but it does tell us that looking for more information will our views improved It just gets us to feel better about the prediction or choice that we will make. Do not over think. Do not over analyze. Realize that more information will make you feel better about your choice but does not improve the outcome.