Signal versus Noise
Distinguishing what’s happening in the market and the direction of important market metrics – the signal – from garbled, inconsistent, and mostly useless data – the noise – is extremely challenging today. Information is contradictory and transient making data and critical events more confusing and indistinguishable. Unusual circumstances brought about by the pandemic, subsequent supply chain interruptions, inconsistent production and demand, and unclear economic forecasts combined for almost unprecedented uncertainty and unpredictability.
Typically, near-term predictions are reasonable and reliable because we have immediately available and fairly accurate data making short-term predictions reasonably accurate. In other words, we can estimate what will happen because we have a good idea of what just happened. But this is not the case today. Predictions based on the near-term past are more muddled now than ever. While we used to be able to say we can see a trend, whether that’s inflation, economic growth, or some other important metric, too much volatility, irrelevance, and lack of applicability (after all, who is going to project from a base that includes a pandemic impacting global supply chains and production?), we really can’t reasonably rely on any of that data to try to find a trend or connect the dots generating a near-term forecast with any meaningful depth of data and understanding
These challenges create more uncertainty, and then it begins – a spiral of more uncertainty, less data, increasing uncertainty, less reliability, and so on. Inflation fears, wobbly currency exchange rates and trade, sectors falling out of favor, and overall market jitters all derive from this unstable foundation. The market’s vacillations and emotional back-and-forth are because it cannot realistically gauge the direction of meaningful data, and key metrics are becoming increasingly useless. Less subjective information leads to emotion-based responses and more subjective reactions to the point where each day’s market preamble begins with uncertainty, emotional responses, and hope that everything will be okay and bad economic data will simply go away as time moves on.
Schizophrenia and the Markets
If Mr. Market is an unreliable schizophrenic, he is certainly having his moment in the sun. Each day market commentary is increasingly sounding like a mental ward.
“Things will get better because they always get better, eventually. On the other hand, things will get worse because they haven’t been bad for a while and eventually things go bad. We are going to get inflation because we haven’t had inflation for a while. But even if we have inflation now, I’m not worried because it’s temporary. Wait, we have real inflation and it’s not temporary. We are underestimating the inflationary impact over the long term and assets are grossly overvalued. Transitory inflation will pass, and asset values will continue to rise.”
Any one of these scenarios seems just as valid as any other now. That’s unprecedented.
But Markets are Up
Taking a closer look at market performance doesn’t necessarily give us any clearer vision. Stock markets in the US and Europe are doing well so far this year, including strong earnings and guidance. Asian equities are a little more challenging and have not had the smooth trajectory that US and European stocks had. But there are a lot of issues going on in Asia that compound not only the pandemic’s impact, but political upheavals, strict lockdowns, unprecedented economic controls on valuable global technology companies, and many other components making it even more difficult to weave together a coherent story about what is going on and how to predict what will happen soon.
It is challenging to see the rationality of a steady market increase, but that is what we have been experiencing all year. Markets are not supposed to like uncertainty, yet, this year has produced so much of it, the most common response appears to be to simply ignore it. We have so much uncertainty regarding any reasonable economic recovery coupled with the increasing pervasiveness of the pandemic’s resurgence we’re not sure how to think about how to think about how to predict. The response appears to be to simply get on with things and envision all near-term challenges as temporary.
Repressed fear is a powerful weapon.
Things are Fine Until They’re Not
The markets have reacted to undesirable uncertainty by ignoring it. A reasonable investment strategy this year thus far would have been to simply imagine that things are fine and proceed accordingly. So far, so good. Of course, that’s a little like the guy who says he wants to live forever and assessing the effectiveness of his strategy by saying, “so far, so good.” That’s not the analysis that matters. That seems to describe current market analysis in general.
The market assumes things will be fine until they are not, but the challenge with this “strategy” is that when things turn the other way, they go quite badly very quickly. There is no real way to react effectively, and those who are not prepared will be blindsided – all running for the exits at once just as we saw in the financial crisis of 2008. It is likely that when things turn, it will be a sudden reaction (perhaps to an extraneous factor) and that in turn will not be very pleasant for any investor.
Regardless of whether the market is up, down, or sideways, probably the most reliable forecast is to say that it will be extremely bumpy no matter the direction. Uncertainty is coupled with more unpredictability about extraneous factors that will probably have a dramatic impact but are completely out of our control. The most recent example, of course, is the pandemic – and now the Delta variant.
Withstand and Hedge
Economic growth models are being shellacked by unpredictable events, global reverberations from policy upheaval, and contradictory strategies. One recent example is supply chain interruptions caused by the Delta variant. With no notice, China has closed one of the world’s largest container ports critical to global supply chains. This was based on the reemergence of the virus, and it is likely that many more, and equally as surprising, events will occur. Economic activity anticipated in the fall and for the Christmas shopping season is vulnerable and most likely significantly negatively impacted already. One reasonable prediction is the global economy is going to see more unpredictable disruptions, so the exercise of predicting seems useless.
Trouble is lurking and will bring more volatility more often. The markets do not seem to be braced for frequent and intense movements that will bring uncertainty and volatility, and then because of even more intense and frequent movements.
Good news brings a strong positive reaction, stable news becomes a nonevent, but then a sudden and very strong negative reaction will occur when bad news (inevitably) comes. The pessimists among us know the bad news is coming, the pandemic is not gone, and we have new disruptions happening all the time. The example of the Chinese shipping port being closed is just the vanguard of more unpredictability to come.
Zero tolerance towards the pandemic, increasing infections nonetheless, new lockdowns and restrictions as a result of increasing infections may continue and be pervasive globally. Once again, we are seeing these events unfolding, but they are not predictable, nor will the market trajectory impacted by these events be predictable.
So how do we deal with all this? The best response to unpredictable situations is to not predict. In other words, don’t build an investment strategy based on long-held assumptions when there are so many unknowns and so much uncertainty. The best strategy against the possible flood is not to hope the water goes someplace else. This is analogous to the “so far, so good” strategy where failure seems inevitable.
In Confusion, there is Profit
There are core holdings that withstand volatility, and although limited, these make sense in any scenario and are a core investment strategy. But with uncertainty comes the opportunity to profit. Beyond a core set of long-term investments immune to volatility (or that recover quickly from volatility), there are two other pillars on which to base an investment strategy today.
One pillar is a portfolio that withstands volatility (examples include high-yielding equities with strong underlying credit quality). The other pillar is a portfolio of counterbalancing assets and securities that profit from volatility (these include derivatives and futures contracts, as well as algorithmic trading of volatile portfolios). All three pillars in combination are essential components to a successful investment strategy, given in today’s market conditions.
More intense volatility occurring more often will be characteristic of this market from now on. An investment strategy must withstand and profit from this. The only clear signal from the market is that there is far too much noise and not enough of a clear signal. Without clarity, determining an investment strategy is flying blind with no instruments. Core holdings combined with an ability to withstand and profit from volatility and unpredictability are essential for investors today.