Future Savvy: Quality in Foresight

In Monday’s Washington Post, under an Op-Ed headed ‘Could America Go Broke?’ columnist Robert Samuelson raises the prospect of the U.S. or another major economy defaulting on its national debt. Says Samuelson: “It’s still a very, very long shot, but it’s no longer entirely unimaginable. Governments of rich countries are borrowing so much that it’s conceivable that one day the twin assumptions underlying their burgeoning debt (that lenders will continue to lend and that governments will continue to pay) might collapse… The question is so unfamiliar that the past provides few clues to the future.”

Well, this raises the question of whether the past tells us anything about the future, and if so what? There’s a common wisdom attributed to Mark Twain (why is it that aphorisms are always attributed to Twain or Winston Churchill?) that goes: “History doesn’t repeat itself, but it often rhymes,” and this is the position that most educated future-thinkers would hold.

So what would the ‘rhyme’ be? From cases such as Argentina, Russia, South Africa, and many developing world countries over the past 50 years: lenders loose confidence in a country’s ability to repay on its national bonds and stop lending; the country is faced with a choice of drastic spending cuts (great social and humanitarian cost) or major tax increases (pointless, because it stifles business, therefore lowers tax revenue) or default. Going broke, into national “Chapter 11,” suing for time and ‘debt restructuring’ becomes the best among the bad options event though it pretty much ensures a deep and dark recession.
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Thinking the unthinkable

Could this be the future of America? As I’ve written before here and other places, after the ‘unimaginable’ Credit Crunch was ignored due to its ‘low probability,’ it’s a relief to know that remote but plausible outcomes with serious consequences are getting attention, at least in the Washington Post.

Clearly major economies are in a more precarious situation than they were 5 years ago. Too much debt is always precarious, for the smallest household or the biggest country alike. On the other hand, an economy’s size and enduring wealth counts too. As Samuelson observes, it created the unexpected effect in Japan’s case where debt at 200% of GDP (America’s is currently about 40%) should have raised the cost of its debt (lower confidence of repayment) but this hasn’t happened because domestic Japanese households and businesses rather than foreigners have easily (and confidently) bought the debt — and this may well hold true for the U.S. too. In other words, the rhyme may go this way.

The ‘more likely’ future is incremental raising of taxes and lowering of public service provision as Western economies incrementally claw their way back to stability. But at least this default wild card on the margins of plausibility has the oxygen of some attention and this is no bad thing. As with all good foresight work, it predicts nothing, but it does allow us to think through the roadmap to the outcome, and press for the right decisions now, in plenty of time and in a measured way.

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Prediction markets have been in the news a lot for their forecasting potential. These markets – where participants buy and sell bets as to whether future events happen or not – mimic “real” securities markets, so it stands to reason that real markets are predictive too, and they are.

My question, as the Dow Jones Industrial Average (DJIA), and the FTSE100, the DAX, the Hang Seng and so on have hit a decade lows is, what is this predicting, if anything? What is the long-term value of this prediction, and could it be used to make better decisions in the real world?
We know that the value of a common stock – a share in a company – is based ultimately on the returns (dividends) it will bring. Buyers and sellers therefore derive a daily market price based on their views of the share’s expected, that is, predicted future payback. The greater the expectation, the greater the price. A high price vis a vis earnings (P/E ratio) suggests confidence in future earnings, and vice versa.
Therefore the current steep fall in share prices is an expectation of (crowd prediction of) lower future payouts. Of course the complexity in human-prediction situations is that this basic level is also overlayed with a meta-level: people are not only trying to figure out what will happen, they are trying to figure out what others think will happen. So falling PE ratios are an expectation of what others will do (predicting they will continue to sell.)

Madness or not?
One of the perplexing things about the markets is they very often seem to react opposite to what is expected; to what would be common sense. They often fall on good news, rise on bad news, close unchanged on big news, and so on. Although there is – famously much irrational behavior and herd instinct in the market – you don’t get hundreds of thousands of decision-makers wagering significant money not using common sense.
What is going on, of course, is that the market has often already risen or fallen in prediction of the news. When a new condition – an interest rate move, for example – is imminent, the market will move to “price in” the expectation. If market participants as a whole have called the future correctly the market will not move much on announcement.

Pricing-in the future
Because of this predictive component to group decision-making in market situations, the stock market as a whole is a classic leading indicator of the real economy. When prices move they may be taken as the crowd “pricing-in” a future prediction. So markets will fall ahead of real economic problems (they may continue to fall, as now, during steep economic declines.) But they will also turn up well before any real, measurable upturn.

By the way, there is little doubt it will overshoot in this time, as it always does. This is because, as in prediction markets, the wisdom of crowds can predict the trend but not the turn. Trend extrapolation will never show you the key shifts, and this is why predicting the bottom or top of a market is so hard.

The point, for market speculators, is that long before the real gloom is over the markets will be zooming upwards. The point for the rest of us is that recession times will be with us even after the markets move up. In the long term the market will go up. Like death and taxes, it’s the surest thing there is.

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