Tell Me Again About Your Models

Despite (and often because of), my overtly pessimistic take on the plight of humanity, I find occasion to laugh more often than I probably should throughout the day.

Understatements are a perpetual source of amusement for me. People make them all the time, especially in the market context. On Tuesday, for example, while summarizing new research from Ned Davis’s Ed Clissold, one Bloomberg reporter wrote that “assessing the exact probability” of an equity correction that “result[s] in a mini bear-market” between now and the end of the year “isn’t easy.”

No, it surely isn’t. In fact, it’s basically impossible.

As I’m always keen to remind folks, if anyone had anything like a reliable model for “assessing the exact probability” of equity corrections, you wouldn’t know about it. They’d have built it into an algo, hit “go” and retired to… I don’t know, and island somewhere. (Wink, wink.)

That said, Clissold reckoned that, based on a pair of models that purport to gauge the behavior of US stocks during comparable cycles, one of the two suggests “a median S&P 500 drop of 18% over 6.8 months.”

You can go ahead and laugh. And not because it’s necessarily wrong. Rather, because without exception, attempting that kind of precision (both in terms of guessing the magnitude and timing of a pullback) is an exercise in abject futility.

What is the S&P 500 (or any benchmark, for that matter)? The S&P 500 is an index which, stripped of the niceties, just measures the trajectory and relative value of corporate profits (which capture the business cycle) plus a premium (discount) that corresponds to the current level of euphoria (despair) among market participants, adjusted for hedging flows and buying (selling) associated with a hodgepodge of systematic strategies that adjust exposure based on volatility. That’s pretty much it.

You can forecast (and discount) profits and you can model the mechanical flows, but you can’t accurately predict when, why or even how humans will experience ecstasy and depression.

That definition explains why “buy and hold” works so well and also why people like Nomura’s Charlie McElligott can nail tactical call after tactical call, but also why, despite our best efforts, we’re all generally bereft when it comes to projecting where equities will be in six months, one year, or even three years.

On a longer horizon, simply being confident that capitalism will plod along, generally unimpeded, is a good enough rationale for owning an index fund. On a very short horizon, being able to model systematic flows can help you predict (or at least make sense of) the daily zigs and zags. But nobody (and no model) can help you very much in the medium-term, because that’s where manias and fear live, and you can’t model those.

In any case, that’s a window into the kinds of things I muse about internally on days like these — days when folks are just waiting around on the oxymoronic “important non-event” or, as Paul Tudor Jones billed the June FOMC during a pointless CNBC cameo, “the most important Fed meeting in Jay Powell’s career.”

Writing in his latest, Deutsche Bank’s Aleksandar Kocic noted that “the Fed’s shift to average inflation targeting came without a firm commitment to a particular window of averaging [and] by that maneuver, the [Committee] retained an option to select the window that would ex-post exonerate its stance without affecting its credibility.” That’s some insightful analysis. “This offers the Fed considerable flexibility given the trajectory of inflation in the last decade,” Kocic added.

Parsing the data is still largely a pointless exercise, if for no other reason than the Fed is sure to ignore it, at least until another two NFP prints are on the books. Retail sales missed on Tuesday except, when you take account of revisions to April’s (no longer disappointing) report, it was a wash. PPI came in hot, but despite being a technical “surprise” (i.e., above consensus), nobody was literally surprised. Empire missed, but prices paid fell. And so on. Someone called it a “mixed bag.” I’ll call it “noise.”

Commodities are coming off the boil. Lumber is down ~40% from the highs and copper has cooled, but then there’s crude, which traded at the highest levels since October 2018 Tuesday (figure below, with breakevens, which are down from multi-year peaks).

Apparently, Trafigura CEO Jeremy Weir thinks it’s possible oil will trade in the triple-digits again thanks, in part anyway, to underinvestment. $100 is a long way from negative $35.

What does it all mean? How does it all fit together?

Who knows. There are conflicting signals everywhere you look, efforts to craft coherent narratives notwithstanding. The Fed told you on Wednesday just how confounding it all is.

Writing earlier this week, Goldman’s Peter Oppenheimer noted that “investors didn’t really expect the high levels of inflation in the early 1970s to persist, at least to begin with [and] they were willing to accept a relatively low yield compared with reported inflation as it began to spike.” That’s where we are now — with a disconnect between rates and realized inflation.

“CPI continues to rise and rates continue to ignore it,” Deutsche’s Kocic remarked, in the same noted cited above. “The new CPI print and subsequent (absence of) reaction of rates underscore the widening of the formal disconnect between the two as well as demand for conditional interpretation of the CPI index in the context of the post-COVID developments,” he added.

Commenting further on the last real inflationary episode in the US, Goldman’s Oppenheimer recalled that “it took some time for expectations to adjust to the reality that a high inflation regime was likely to last.”

Once inflation was embedded, investors were similarly reluctant to accept that it was likely to recede. The figure (below, from Goldman) gives you some additional historical context.

“By the time inflation started to come down in the early 1980s, investors were doubtful that this was the start of a new trend,” Oppenheimer went on to say. “Bond yields remained much higher than reported inflation for a long time.”

Now, tell me again about your models and predictions.