Commodity shocks and financial markets

 

The first quarter is a commodity shock quarter. We had the gold and silver bubble and it bursting at the end of Jnauary. That seems like ancient history versus all the uncertainty from the war in Iran. The broad market is off more than 5%, yet the energy sector is up over 35%. More importantly, the price of oil is up over 50%, and gasoline futures are growing by 60%. There is a clear link between oil price shocks and financial markets. It is a one-two punch to equity and bond markets, and we have strong evidence of its effect across decades, dating back to the shocks of the early 1970s. Most of these large shocks are self-induced through violence. 

Beyond the magnitude of the shock, the key issue is the time required to return to normality. Short-term shocks can have a strong impact on short-term returns but then reverse quickly. The longer the shock lasts, the more likely it is to have a real effect on growth and inflation. The effect on growth is simple. An increase in energy prices is a tax on consumers and production. However, the US economy is less oil-price-sensitive than it was in the 1970’s, so it is hard to use this period as a control or base case. For inflation, the impact is closely tied to the actions of the central bank. An oil price shock is a relative price change, not an increase in the general price level; however, if the Fed lowers interest rates to support the economy, this price change can trigger an inflation surge.

All eyes are on whether this conflict will be prolonged, and with each day it continues, this short-term shock will be revised into a larger, economy-wide recession-inducing crisis. For many in the emerging markets, energy shortages are real and already disrupting growth.

Reducing anxiety choice overload

When there is high uncertainty, there is anxiety in making a choice. Who wants to mkae a bad choice? The issue is then trying to reduce the level of anxiety to allow for better decision-making. Some simple rules can help reduce anxiety. 

Minimize the options - If there are fewer choices, it is easier to make a decision. One way to reduce the options is to categorize the choices. Allow for one option within a grouping. For example, if you are worried about an energy shock, break down the choice between risk-on and risk-off, and within each category, allow for two options.  

Stick to what you know - If there is an option that is not well known to you, then drop it from the choice list. Active decision-making may not be the time to learn about new options. It can be an expensive education. 

Do not regret wrong decisions - The anxiety of choice is based on the regret from making the wrong decision, so another simple way to reduce anxiety is to think about minimizing regret. What is the downside of making a wrong choice? It is important to remember that there are acts of commission, the actions we take, and acts of omission, the actions we don’t take, and regret is greatest for commission. Take the time to ensure that your actions are well-grounded to reduce regret.

Debiasing decisions - Some simple rules to follow

We all face biases or bring them to decision-making, so it is critical to develop strategies to reduce the risk of bias. The bias problem applies to both quantitative and discretionary decisions. Just because you are using a model does ot mean that you are immune to biases. There should be a checklist to review the potential impact of biased thinking. The paper “A user’s guide to debiasing” does a good job of exploring the basics of reducing biases and improving the quality of judgment in decision-making. Debiasing reduces logical inconsistencies and misperceptions or misjudgments of reality. Debiasing is not the same as gathering more factual informaiton. The objective is to improve decisions given a specific set of information.

Categorizing debiasing methods distinguishes between the person and the task. Improving the person requires training to help the decision-maker overcome their limitations. The second approach is to modify the environment to match the thinking required.

Many of the sources of our biases come from the confusion between system 1, fast and automatic responses, and system 2, which requires slower and more deliberate thinking. It is important to distinguish between narrow thinking and shallow thinking. Narrow thinking focuses attention on a single category of objectives and crowds out the ability to identify other alternative objectives. Shallow thinking devotes too little effort to the required task. For any decision, there has to be a level of readiness to perform better decision-making. 

The person can be modified through better education that generates more alternatives, tempers optimism, focuses on improving judgmental accuracy, and assesses uncertainty. Decision-makers can use defaults to get closer to making better decisions through regular processing, nudges to induce reflection through prompts or planned interruptions, and the formation of a set of active choices. If this can be done for the individual, a similar process can be applied to the organization. 

AI - all the time for business

 

You have to love some of these charts that bundle ideas that seem to be unrelated. In this case, we find that the word "AI" is used more often on earnings calss than the word "earnings". We should expect that the word earnings is fairly static on earnings calls, but the explosion of the word AI suggests that this is the what management and investors have as their main focus. For management, using the the word AI convesy what they are doing new to address issues of tehcnology and effciency. Investors want to know how firms are using new technology. The question is whether AI will actually lead to the efficiency gains that many expect.