While we ponder  the economy and markets and equity returns it is important to be firmly rooted in probabilities rather than certainties.

The first step in this process is to be very clear what is fact, what is informed opinion and what is simply future forecasting. Forecasting the future is a fool’s errand.

Very important to understand the difference.

Some history might help me explain:

In 2007 we thought the market was going to go down in the year or two to come based on equity over-valuation, the rapid erosion of the housing bubble, and the major excesses playing themselves out in a speculative market. This was not a forecast exactly but rather we thought it was a likely outcome with a very high probability of 80%.

In our work an 80% probability is very rare. I have been conscious of this level of certainty only twice in the last 20 years.

Our current outlook for stocks to reach ridiculously cheap levels sometime in the next 5 years only has about a 60% probability. Still high but less certain and almost meaningless given the time frame.

That leads us to a discussion of risk. By 1999 (during the tech bubble) I was certain stocks were headed for a fall. I did not pretend to know when, but thought it would come within months or a year at most. Stocks were ridiculously overvalued. Managing the risk of an equity collapse was job 1. Recognize that the possible outcomes from the vantage point of 1/1/99 included a wide range of possibilities from +15% to -35%. The downside was much more severe a possibility than the possible upside would compensate for. I advised anyone who would listen to get out of stocks.

In the event stocks rose almost 24% that year. Most people who had heeded my advice thought I was nuts. Speculative fever was abroad in the land and everyone knew that the tech revolution was going to change everything. No more recessions, only growth! A couple of my friends who had reduced equity exposure actually went back into the market.

The market started its decline for real at the end of August 2000 and bottomed down 50% in March of 2003. Friends who heeded my advice in early 1999 managed to avoid a 33% decline.

The point of this story of humility and ultimate redemption is that when we look backward the outcome could have been different. The speculation might have continued for two years or more beyond 2000. Looking forward from 1/1/1999 there were myriad possibilities. The judgment made at the time was that the downside risk was A major risk and therefore that possibility required action. Owning 60% stocks in a down 50% market is devastating to wealth.

This is an important discussion that will continue in coming weeks.

OSF