The market prices in the future. But how far in advance?

The market prices in the future. But how far in advance?

It’s that time of year. The news is full of forecasts for 2019 and stocktakes of 2018. So I’m going to ponder something different. What I think is the most important question of 2019:

How many steps ahead do you need to be to profit this year?

Do you need to look beyond the horizon, or just through the fog?

I better explain what I mean.

Theory says that financial markets are forward looking. They predict the future and then price it in.

That’s why, sometimes, when something big happens, it doesn’t move the market.

The real question at hand is: What was the market expecting?

Timing is everything

If the big event was expected, there’s no reason to anticipate a market reaction at all.

2018 saw markets price in Italian budget debacles, a recession in the EU, tighter monetary policy at the Federal Reserve in the US, and plenty more.

Markets tumbled.

If you had forecast all this in 1983, and put your money where your mouth was, it wouldn’t have worked out so well. You were much too early.

If you’d predicted those events after the market already priced them in, it wouldn’t have worked out either. You still lost money before the Italian budget belligerence finally hit the news cycle and European GDP growth came in disappointing.

The market was one step ahead of you.

To make money, you have to predict something just before the market does.

Not just before it happens.

But before the market expects it to happen.

That brings us back to our original question: How many steps ahead do you have to be in 2019?

It’s a tough question to answer. But it’s just as important as being right about your forecasts.

It’s when everyone else reacts that matters

I’ve been exposing the dodgy lending practices of Australian banks since 2012. And I explained how, as soon as house prices flatline briefly, this would trigger a crash in house prices.

But house prices didn’t turn down until recently, many years after my predictions were long forgotten. I was too many steps ahead. Even if I was right about the true nature of Australia’s lenders.

In 2018, the opposite happened.

I predicted the stock and bond market turmoil two weeks before it broke out, both in May and September. And the markets tumbled for the precise reasons I warned about, too.

But it was the Federal Reserve’s decision to ignore the turmoil which really unleashed the plunge in stocks. I didn’t expect the Fed to continue to raise rates while stocks and bonds around the world plunged. Nor did the market. That’s how 2018 got so out of hand.

In both cases, I was right. But it was the timing that made the second set of predictions useful.

Then again, two weeks might not be enough warning.

But do you see how being just in front of the market’s anticipation is the key?

You can’t just predict what will happen. Nor when it will happen.

You also have to predict when everyone else will realise what will happen.

The trouble is, the market’s foresight isn’t exactly stable. It gets things wrong.

And how far it looks into the future can change.

Volatility increases market uncertainty

2018 showed that the market’s ability to forecast is a bit iffy. The volatility of stocks and bonds went from record lows in 2017 to very high levels in 2018.

The market’s time horizon shortened alongside the uncertainty.

In other words, the market was pricing in what was going to happen one step ahead instead of two, because it was so hard to predict what would happen in step one.

Markets struggled to come to grips with the likes of Donald Trump and the Italian government. Their tweets triggered massive reactions, despite being perfectly foreseeable.

So the market didn’t seem to be looking far ahead in 2018.

It just reacted to the news cycle each day.

That means investors needed to pay attention to what was happening each day instead of tomorrow, next week or next year. If they wanted to make money, that is.

In 2017, the time horizon was much longer. You should’ve been worrying about 2018, and taking advantage of low volatility and high market prices by selling out.

So, what do we know about 2019 that’ll help you decide how far ahead to forecast?

2018 priced in the chaos to come in 2019

The things that moved markets in 2018 were about what would actually take place in 2019.

Italy’s budget drama was about the 2019 budget — it must actually find willing buyers to refinance and finance its spending this year.

And the spending policies which caused all the ruckus were delayed, not cancelled. So 2019 will see a repeat of 2018’s budget battle. But with less economic growth to keep the deficit figures under control.

Trump’s trade war kicks off for real this year, if he doesn’t get his way.

The EU, or just parts of it, will be in an official recession come 2019. Economists polled by the Financial Times are all still forecasting growth.

Australia’s house prices are falling in anticipation of the Royal Commission’s findings.

And there’s the realisation that, without rising house prices, the proportion of people who can afford to buy houses is much smaller.

There’s a reason all those loan applications had to be fudged in the first place.

Europe’s political revolution in 2018 was nothing compared to the EU elections coming this year. Imagine if those causing political and budget chaos were commandeering EU policy from the inside.

Brexit is about as settled as an Australian prime minster. There’s a real potential for the political spat to turn vindictive and disrupt financial markets.

Do you see the nature of the problem facing us in 2019? The turmoil of 2018 didn’t settle any of the issues that began to be priced in. Nothing was resolved.

The market will continue its short-time horizon and volatility in 2019.

Don’t look too far ahead. Your portfolio could hit an iceberg before you get to 2020.

Until next time,

Nick Hubble Signature

International Contributor,
The Daily Reckoning Australia weekend edition