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A forecast is your friend... until it isn't

“The best way to predict the future is to create it” - Abraham Lincoln


Applogies, it has been a while since our last post - been suffering from a serious case of writer's block. On that note, if you have any suggestions for an article, please email them to bytesizestory@gmail.com. Onwards to the article.


Follow many equity indexes and one of the clear trends you will see is an ongoing increase in the index, and underlying assets (ie the actual shares). Not necessarily day-to-day, but over time. The Dow Jones index is a good example. An investor in the 1980s had a lot to look forward to.


This leads people to suggest that long term you will come out on top if you invest in equity. It's not unreasonable. Over the time horizon people often talk about, it's accurate. Plus, on average, you will beat the return from keeping your money in the bank.


People see a trend and assume it will continue. Of course, acknowledging short-term variance, but generally expecting a long-term upwards trajectory.


But what if we were in May 199,1 looking at investing in the Nikkei 225? Different story right? Despite stellar growth from the 1960s to 80s, Japan's growth and equity markets would end up being stagnant over the next three decades.


This isn't to say that the Dow Jones and Nikkei 225 will follow a similar pattern, just that historical trends can be deceiving.


Predictability is comforting


Despite first impressions, this article is not about equities and indexes. It's about sequences and how difficult it is to understand the ‘direction of travel’ for a series of events - ie a forecast.


Some sequences occur over short periods - hours or days. Others can take much longer to fully play out. A sequence could be something simple like a workweek. Or more complex, like the fall of empires.


People don't really get sequences, particularly long-term sequences. They are difficult to understand because we might have only experienced part of it. Different 'parts' of a sequence may have different trends and only start to make sense when we can see the whole, often with the benefit of hindsight.


Most people have recency bias which is part of why forecasts often look like what is happening today, but bigger - certainly this is the case in financial markets. People struggle to even conceptualise a scenario outside of current trends, and even if they can, they are constrained by herd mentality.


Herd mentality, consensus-driven thinking, and skewed incentives amplify trend following. Nobody wants to be the one to stop the music or go against the consensus. To do so creates career risk and the possibility of being labeled a fool, better to be wrong along with everyone else. Or worse… wrong when everyone else is right if you go against the grain.


A house price crash in New Zealand is a good example. Nobody would want to predict it, but a price crash could happen if the global cost of capital rose materially, given how indebted the country is. Do you want to be the bank that stops lending before everyone else, just before bonus time, when you have targets to meet? Of course not.


Nothing is more comforting than a good trend. An established trend suggests that the future will look a lot like the past and the illusion that one can anticipate what is to come with more certainty than is really there.


USA unemployment rate 2015 - 2021 including COVID-19

It's difficult to know where you are in a sequence


Our investor in Japan in the 1980's couldn't have known with any certainty what the next 30 years would bring. They could show us statistical predictions based on a set of explanatory variables. They could even tell us about how the market had responded historically to certain events.


But they could not know what might change the trend. This is what makes forecasting so dam hard. The pattern could shift entirely. It might be longer, shorter or follow a completely different pattern.


Let's consider the trend in equities again, and what’s been driving their increase in value.


Falling interest rates, integration of emerging markets into the global economy, ongoing globalisation, peace between major powers, demographic dividends, falling corporate tax rates and business-friendly capitalist democracies have all been features of the global economy over the past 30-40 years.


Without these, can markets continue to rise... and if they can... are they priced to do so today? Or do levels need to reset before that is possible (like Japan)?


Trends can't necessarily repeat if what is driving the trend changes, or has run its course. Ultimately, you can't necessarily predict, but you can prepare. But that's another article.


 

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