It took me a long time to learn that instruments and forecasts don’t make money, risk management does. If you are in the capital markets, forecasting is paid work, a job, a vocation. Predictions are all over the place. What’s a prediction? Euro will die or Nifty will reach 8,000 or Gold will rise are all predictions. “That new Tom Cruise film will be a hit.” Whenever we say “will”, we attach a 100 per cent probability to the event. A lot of times I ask, “How can you be 100 per cent sure?”
Is there a way to outperform the market and not use a prediction? Well, we may not have cured ourselves from the forecasting passion (or vice) yet, but as we move towards systems, the only forecast we would like to do is that performance is cyclical and the worst performers of yesterday become the winners of tomorrow. This phenomenon of reversion is not a prediction or a forecast, but a visible reversion seen in outliers. But then, what should we do about our need to forecast or follow our intuitions?
According to Daniel Kahneman, “Following our intuitions is more natural and somehow more pleasant, than acting against them. It’s natural to generate overconfident judgments because confidence, as we have seen, is determined by the coherence of the best story. However, we are not all rational, and some of us may need the security of distorted estimates to avoid paralysis. If you choose to delude yourself by accepting extreme predictions, however, you will do well to remain aware of your self-indulgence.”
So, much we suffer from forecasting that we just can’t leave an opportunity to predict. My network is full of researchers and thinkers and just like me, most of them suffer from this vice. Recently, I left a message from a friend.
MP: Happy Birthday, Have a great decade.
Friend: “Thank you! Salute to the Decade indeed, while I am confident that this decade will treat me well, I cannot say the same for the markets. A wicked bear market will crush equities from 2012 to Spring 2013 and 2014-15 into 2016.”
My friend had again assigned a 100 per cent probability. He thanked me and left with a return gift, a forecast. There is another thing about predictions. A majority of these are extreme and just a few of the predictions are moderate. Now I was trapped. My friend’s forecast made me think and all my effort to stay away from forecasting pulled me in like a black hole. How can his extreme prediction be correct?
I tried to look at evidences. Europe is a large trading partner for most of the world and looking at some global assets after rebasing them in euro might show interesting insights. Redenominating Dow in euro terms suggests that Dow (euro) is more positive than Dow in dollar terms. Now, one may say this is correct because euro lost value versus the dollar. However, the points we are making here are two. One, currency movements do play a partial role in the performance of assets. Second, if Dow looks negative in dollar terms and positive in euro terms, is the Dow going up or down in 2012? This is a relevant question and suggests that focusing on local currency may not give a complete picture about the market trend. If you redenominate an asset in another currency, a bear might look like a bull.
We also rebased the Nifty in euro terms. What did we observe? First, the Nifty (in euro terms) is already near December 2011 lows. Second, the Nifty has already retraced 61.8 per cent of the move from 2009 lows till November 2010 highs. Third, the worst BSEPower sector has already reached 2009 lows.
What did this mean? This means that despite the structural problem of debt and currency union in Europe, Indian assets and currencies keep depreciating in euro value terms. On one side this is harder to explain fundamentally but on the other one can call it temporal inertia where Indian assets continue to diverge in value against its global peers reaching a point of snap back. Though Indian markets remain negative, expecting them to go lower down till 2009 lows is an extremity.
The reasons for snap back were very simple. First, because markets are connected together with performance, there is always an outperformer, be it an asset class or a stock. Sooner or later the reversion from extreme happens. Second, the very fact that Nifty (euro) was already in a depressed euro valuation state, the performance reversion for Indian assets looked imminent. Third, though I indulged in a vice, my forecast was moderate and not extreme, I was looking at probabilities not certainties.
The author is CMT, and Co-Founder, Orpheus CAPITALS, a global alternative research firm