Is forecasting entertainment?

 

“We want a lot of things from our forecasters, and accuracy is often not the first thing. We look to forecasters for ideological reassurance, we look to forecasters for entertainment, and we look to forecasters for minimizing regret functions of various sorts.” - Phil Tetlock

Forecasters often get it wrong, so why do we follow them? There must be other reason we listen or follow forecasts in our decision-making. We should be able to do the job ourselves. Is it just the expectation that there is a chance that the forecast will be right and that will make all the difference? We are will not take a low chance of success because the gain when right will be so much greater. This seems like an odd way of thinking. It can minimize our regret. We can place the blame for a bad forecast on someone else. It is human nature to not take responsibility for our mistakes. It could give us reassurance. Investors look for validation from others. This makes sense. Perhaps we ask for or need dialogue. We want to hear about the opinions of others to make a better decision. Is this entertainment or is it an important part of the deicsion process? 

The one thing we do know is that we don't need forecasters for their forecasting skill. 

World uncertainty and trade uncertainty rising

 

The World Uncertainty and Trade Uncertainty Indices are both showing increases over the last quarter consistent with the new era of Trump. The uncertainty is nowhere near the levels seen during the first Trump Administration, but we are early in the process of determining what will be the policy actions. The World Uncertainty index is pushing to levels seen during the first Ukraine War, yet the level of uncertainty is not near the Brexit levels. 

While this index may not help with trades, it does provide information on how to adjust asset allocation. Higher uncertainty will create an environment that should be focused on holding cash and lower risk assets. The range of possible returns should be widened for 2025.

Irving Fisher's view on valuation

 

when values are considered, the causal relation is not from present to the future but from the future to present. - Irving Fisher 

While Irving Fisher in the investment committee is best known for his bad predictions before the 1920's stock market crash where he lost everything, he was towering force in economic pre-Keynes. Unfortunately, trading is not the same as theorizing. Nevertheless, his insights on looking to future expectations discounted back to the present is the critical idea behind all financial valuation. 

The focus on any valuation is not about looking at the past and not extrapolating but a focus on discounting the future cash flows or future expectations. An expectations market can move in a lot of direction and requires more work because an investor has to measure the expectations of others and weight their own view with the view of others. 

Financial Contagion - It is has not gone away

 

 

We can think of the 21st century as the age of financial contagion. Perhaps we have not seen more contagion in the 21st century, but it seems that they when they do occur, these contagion events have been more impactful over the last two decades. Information moves more swiftly through markets. Investors react more quickly to these new events which change expectations. There are more short-term agents in the marketplace. All these factors contribute to the large potential contagion events in currencies, the stock market, and banking. With contagion comes crises, there are spillover effects that create adverse markets moves. 

There are several definitions for a contagion event. Contagion is a significant increase in the probability of a crisis in other markets, when there is a crisis in one market. Put differently, a contagion is an increase in the volatility of associated markets or spillover from an increase in volatility in one market. A contagion will lead to higher cross-market correlations, co-movements, or an adverse price move when one market is hit with a market shock. A contagion occurs when the transmission channel changes after a shock in one market. 

The cause of a contagion is based on financial interdependence either through similarity in information shocks or portfolio effects. If there is a shock with one market, there may be a change in the probability of a down moves in other markets which may have similarity with the shocked market. The shock will be based on new information that shifts expectations. This new information will change the expectations for a broader set of markets and lead to a more general sell-off. Along with the expectational channel, there is also a leverage and portfolio effect. if there is a decline in one market which increases portfolio volatility, there will be a corresponding in position risk as an investor delevers, or adjusts allocations. There will be an income and substitution effect. The price decline in one asset will lead to a position adjustment as part of risk management. The portfolio effect of higher volatility may lead to closing multiple positions. A good review article is "A Primer on Financial Contagion"