Judging out probabilities – the big picture

Why is the market rallying and/or falling every day? They gain only to give them back; Or they sell hard to recoup losses later.

I suspect this is because the dispersion of possible future outcomes is so unusually wide. Meaning, what investors envision as the most likely outcome is all over the map.

Perhaps a weather analogy can help explain: From October, let’s imagine a typical weather report: 80% chance of sunshine, slight chance of rain overnight, daytime highs 60-67 degrees, dropping to 52-60 in the evening. If you’re going away for the weekend, you’ll have a good idea of ​​what clothes to pack for that trip.

Markets are often like this: the economy is doing well, earnings are good, inflation is moderate, the overall trend is up. In this environment, it’s a pretty safe bet to assume you’re going to end up somewhere close to the historical average – a total return of 6.7% real (8-9% nominal). This is especially true if you are looking at a longer time frame.

But imagine you get a very different forecast: 40% chance of 80-degree sunshine, 30% chance of tornadoes, 20% chance of blizzards, and 10% chance of torrential rain. How do you pack your small carry-on bag? that weekend?

The answer is probably that you don’t want to go on that trip.

There is no market option for predicting bad weather. So, they are acting as if we are more in the latter situation than the former. The possible outcomes seem to be spread widely over a wide range of possibilities, from profoundly negative to strongly positive, each of which seems more or less equally likely:

– Upward (downward) earnings shocks resulting in market rallies (sell offs);
– Inflation remains sticky (temporary) prompting the FOMC to tighten (pause);
– OPEC oil supply and Ukraine war worsen (good) sending prices higher (lower)
– A too-aggressive (soft) Fed leads to a painful recession (strong recovery);
– Ukraine spiral (end) Russian invasion with catastrophic (positive) consequences;
– Pass the budget (standoff) and finance the government (shut down);
– mid-terms (failed) provide clarity and elections (falsely challenged) are certified;

When unexpected outcomes are equally likely to occur, each new piece of news (however marginal) takes on greater significance. Hence, each new tidbit gives an active allocation of capital paroxysms.

I have been increasingly constructive on these markets, but I am very aware that at least for the foreseeable future, there is an influx of data, news and events that are very negative for stock prices. It’s just as possible that there’s another future market that shakes out despite (or more precisely because of) the bad news and the rally flow.

I like to say the future is unknown and unknowable. But when it’s difficult to assess the full range of possible outcomes, it makes the market appear volatile, indecisive and trendless.

No one ever said discounting future cash flows was easy…

in the past:
Jumping Down (October 14, 2022)

7th Inning Stretch (September 30, 2022)

Counter trend? (August 15, 2022)

One-sided Market (September 29, 2021)

The end of the secular bull? Not So Fast (April 3, 2020)

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