Counterfactuals, history, and market analysis

Counterfactuals of past events have taken the history profession by storm. While not always liked by traditional historians, the process of thinking through counterfactual examples has enlivened historical thinking and has created fresh views about critical historical events. Other say that these what-ifs are not really the study of history but just speculation and conjecture about an event - a parlor game that is not worth serious consideration. Counterfactuals investigate the chain of causality in hindsight. 

History counterfactuals have especially focused on big events like war to ask the simple question of what would have happened if the winner became the vanquished in a given battle. Would the tide of history have changed? If conditions change, would we live in an alternative universe, or is the tide of history inevitable. 

Counterfactuals can also be applied to economics and finance through simple thought experiments. What if Jerome Powell was not the chairman of the Fed? What if Great Britain did not have Brexit? What if there was less QE after March 2020? Of course, these examples are backward looking. The more useful exercise is to use counterfactuals about future events. 

Thought experiments, not forming a decision tree of probabilities, are often the bread and butter for the good forecaster. Counterfactuals can be run forward to develop different vivid scenarios and create alternative worlds. What if a Fed taper was announced tomorrow? These scenarios, often relying on past thought experiments, are foundational to market forecasting. Forecasting based on past data, probability estimates, and thought experiments enrich the choices of what may be possible. 

The classic proverb "For Want of a Nail" can be applied to counterfactual history. What the shoe was properly nailed? 

For Want of a Nail

For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the message was lost.
For want of a message the battle was lost.
For want of a battle the kingdom was lost.

And all for the want of a horseshoe nail. 

Commodity Cross-correlation - Single factor shocks and financialization, then and now

 

The dynamics of commodity trading has always been more complex than other asset classes. The cross-correlation within commodities is surprisingly low relative to other asset classes so there is no simple or well-defined "commodity beta". The markets that go into the commodity asset class bucket is a hodgepodge that do not often move in common. Investing in a commodity basket will give you a very diverse set of risks from weather and global business cycle to logistical uncertainty. 

With such a low cross-correlation, it is hard to say that buying a commodity basket will give inflation protection or strong exposure to the business cycle. To get strong single factor exposure, the cross-correlations must rise. 

Metals, energy, and agriculture prices are often driven by different factors, yet the period surrounding Great Recession showed a remarkable increase in correlation across all markets. Some will state that this was driven by a common factor - the global decline in growth. Other will say this increased correlation was associated with the financialization of commodities through a strong increase in index buying and switching between commodities and other asset classes. 

Disentangling these issues are not easy because we have limited events for comparison. We do know that correlation will rise in a strong recession given a global decrease in demand; however, the pre-GFC period saw increased usage of commodity indexing to gain exposure to this asset class.

We have seen a fall in commodity index trading with the fall in the commodity super-cycle and the great bear market across many commodities. There was a mass exit from this asset class. The environment over the last year has changed. Index trading is increasing, and we are seeing an increase in correlation across many commodities as inflation expectations have risen. 

Commodities will still be more diverse than equities but we expect that commodity cross-correlations will increase. This will lead to common price behavior more closely tied to higher inflation expectations and the desire for portfolio diversification. For the more casual commodity investor, this decline in cross-market dispersion will be positive for their portfolio structuring. 

Sustainable investing continues to grow

The single biggest trend in investing over the last few years has been the movement to sustainable investing. Sustainable investing may now encompass 35% of all invested assets and may total $35 trillion dollars. (See the Global Sustainable Investing Review 2020.) This growth is astounding with $5 trillion investing in the United States over the last two years, yet it is less clear how this has impacted return behavior for individual stocks. 

There are several strategies for sustainable investing, so it is hard to disentangle return behavior in the same way as say market capitalization, value, or momentum. The global study identifies seven key sustainable strategies that range from exclusionary screening to thematic investing, yet the definitions do not provide clear guidance on how stocks can be filtered. There are no set standards.  

The two most popular are exclusionary investing and ESG integration. Exclusionary investing can be as simple as no tobacco stocks while thematic approaches may be a play on clean energy companies. 

At one third of all investing, it is now critical to have a view on sustainable investing and more importantly track the issues and decisions of sustainable investing to look for signs of crowding or price flow dynamics. Exclusionary stocks should see an increase in their risk premium and thematic stocks may see a flood of new money that will push prices above fair valuation. Sustain investing should be a core investing principle but looking for the impact on price is good fundamental investing. 

Where are we and where are we going? The perennial question for investors

 

No amount of sophistication is going to allay the fact that all your knowledge is about the past and all your decisions are about the future. (Ian H. Wilson, former GE executive)

Most analysts spend time focused on the past through conveying information or knowledge. There are descriptions of new data generated. It is placed in context with past events. A time series is reviewed. 

The analysis is about the past. It is just telling us where we are. Meaning is presented through context. Less time is spent on what new information means for the future. This presentation of knowledge is critical and necessary for any discussion of the future. 

I don't blame analysts for their focus on describing the past. I do it myself, yet the hard work is predicting or handicapping the future. Where are we going? A forecast must be made and confidence in that forecast has to be measured. The odds of success should be presented.

Trend followers focus on the past, yet there is clear intellectual honesty in their analysis and a clear focus on the future. There is no misrepresentation. Past prices are turned into trend signals. There is no deep narrative. Manipulations of price are turned into a signal and a decision about the future is made - prices are going higher, lower, or direction cannot be determined. If the perceived future proves to be wrong, there is an exit. 

There are, of course, other ways to convert past knowledge into future decisions, but there is no simpler way to start the process. Alternative forecast should start with the premise that the trend is correct and requires a strong standard to take any opposite position.