Known Unknowns (PIMCO)

Known Unknowns

by Neel Kashkari, Chief Equity Strategist, PIMCO

• ​ We believe investment managers can analyze numerous data sources and apply lessons learned from past economic cycles to make reasonable assessments about the global economic outlook.
• We also believe managers can make reasonable judgments about asset classes over the long term and, through rigorous bottom-up research, develop an edge regarding the outlook for individual companies.
• However, the market as a whole is much better at aggregating all the information that could affect any of the thousands of companies in the stock market than any investor could possibly be. Hence predictions of where the stock market will close on a given date are likely to be wrong.

People love bold predictions. More precisely: People love people who make bold predictions that are eventually proven correct. We tend to put such soothsayers on pedestals and anoint them heroes. And why shouldn’t we? They were able to see important outcomes that the rest of us missed.
Consider two notable examples:

• In 1969 quarterback Joe Namath boldly guaranteed his underdog New York Jets would beat the Baltimore Colts to win the Super Bowl. An audacious prediction, when Namath successfully led his team to beat the Colts he ensured his place in sports history.
• In 1961 President Kennedy called for the nation to land a man on the moon and return him safely to Earth by the end of the decade. At the time an American hadn’t even orbited the Earth, let alone made it to the moon. Considering today it takes almost a decade just to design a new rocket, Kennedy’s call to action from virtually a blank sheet of paper was truly a “moon shot.”

But our memories tend to be skewed: we remember the heroes but often forget the bold predictions that fell flat. For example:

• What was the name of the pastor who predicted the world would end on May 21, 2011? I can’t remember either. I’m sure I would remember had the world actually ended. (Well, maybe not, but you get my point.)
• In December 2007 sell-side equity strategist Abby Joseph Cohen predicted the S&P 500 would climb from 1,463 to reach 1,675 by the end of 2008. Given the brewing financial crisis, this was a bold call. In fact, the crisis dramatically worsened and the S&P 500 ended 2008 at 903. As the U.S. crisis recedes into memory, people have moved on.

Turning on business television, one can hear bold predictions almost daily: Where will interest rates be in the future or what actions will policymakers take to solve the European debt crisis? Every January many strategists predict the level of the stock market at year-end. It’s an annual tradition.

But with so many bold predictions routinely made on every side of virtually every economic issue, it can be hard to determine which predictions to take seriously. How does one make sense of the noise?

I believe two questions are essential to assessing predictions:

First, is the prediction “knowable?” Joe Namath was certainly able to influence the outcome of the Super Bowl. His prediction should have carried more weight than that of the average football commentator. We should pay more attention to those with special insights into knowable topics.

Second, does the person making the prediction have any downside if wrong? While President Kennedy is rightly lauded for setting the country on a path that transformed America’s standing in the world, presidents frequently make such bold calls, and the majority of them expire unfulfilled and unnoticed. For example, in 1983 President Reagan called for development of a missile shield to defend America against a nuclear attack from the Soviet Union; “Star Wars” never came to pass. In 2003 President Bush called for hydrogen cars to be commercially viable by 2020; seven years later President Obama cancelled their funding. There is little downside to Presidents setting ambitious goals – and they might improve their place in history if one of them works out.

In a society where we hoist the heroes but forget the mistakes, incentives are strongly skewed toward making as many bold predictions as possible, because at least a few are bound to hit. We should pay more attention to those who actually have something to lose if they are wrong.

So let’s analyze both questions in the context of predicting markets:

We at PIMCO believe certain investment topics are knowable and some are not knowable. To borrow a phrase from former Defense Secretary Donald Rumsfeld, there are Known Knowns and Known Unknowns. I will leave Unknown Unknowns for a future piece.
Known Knowns:

• Global economic outlook. We believe investment managers can analyze numerous data sources on global economic activity and apply lessons learned from past economic cycles to make reasonable assessments for what the future is likely to hold. This is complicated by changing global dynamics and sometimes unpredictable politics. But a robust economic framework can yield real benefits for investors.
• Relative value among asset classes. Looking at the current prices of securities, such as P/E multiples, dividend yields and expected earnings growth for stocks, and spreads and yields for bonds, in the context of the current economic environment, managers can make reasonable judgments about the overall expected return from asset classes over the long term. From this perspective, managers can determine which asset classes they believe will provide the best risk-adjusted returns over time. Stress testing these assumptions against a range of economic environments is important.
• Outlook for an individual security, be it a stock or bond. Through rigorous bottom-up research, analyzing financial statements, meeting with management, speaking with suppliers, customers and competitors, we believe managers can develop an edge regarding the outlook for individual companies. We will often research a stock only to uncover no special view; we let a lot of pitches go by before we find a stock we like in which we believe we have found an edge.
• However, innovation, business expansions and turnarounds take time. While investment managers may have confidence in a company’s growth plans, whether that expansion takes one quarter or one year to bear fruit can be hard to know. Hence, taking advantage of fundamental research often requires lengthy holding periods. We generally expect to hold stocks for three to five years.

Known Unknowns:

• The level of the stock market on a particular date in the future. Stocks receive cash flows last in the capital structure, so any new information that can affect instruments senior to equities can also affect equities: Political events. Economic events. Interest rate moves. Industry dynamics. Management changes. Product innovation, etc.
• Equity prices are continuously updating to reflect the constant stream of new information that could affect the stock. As described above, we believe we can get to know individual companies well through deep fundamental analysis. But the market as a whole is much better at aggregating all the information that could affect any of the thousands of companies in the stock market than any investor could possibly be.
• Think of an individual trying to compete against a supercomputer that is composed of an almost infinite number of microprocessors working in parallel crunching vast amounts of data as it pours in. The computer isn’t perfect and may not have wisdom, but it has a huge advantage over the analyst. In the short-term, equity markets contain the bulk of available information that should affect stocks.
• As a result, predicting where the Dow will close on a given date is like trying to predict where ocean waves will splash against the Newport Beach pier at a given moment in time. While oceanographers can tell us the general time and average level of high and low tide, they know the natural dynamism of the sea limits their precision to forecasting trends and averages rather than point estimates. We believe the same is true for forecasting the stock market as a whole.

To understand the second question, the downside of being wrong, it is important to consider who is making the prediction. One common group of predictors work for broker-dealers, generating investment ideas hoping investment managers will find their ideas interesting and reward them by trading with their firms. They are incentivized to offer as many ideas as possible. Some are bound to be thought-provoking, and there is little downside if their predictions are wrong: They aren’t actually investing based on their views.

In contrast, investment managers are seeking to generate attractive returns for their clients. Managers make decisions based on their outlook for securities and if they are wrong, there is downside: Clients may not perform as well as they hoped. While PIMCO has sought to generate strong performance for our clients over our 40-year history, we aren’t perfect, and we work hard to get as many of our calls right as possible.

Most of the commentators predicting the level of the Dow at year-end are sell-side analysts rather than investment managers. This makes sense: There is little downside for being wrong most of the time. The interesting question for the investment managers who do partake in such fortune-telling is do they actually utilize their own predictions? Most equity investment managers are managing portfolios that are required to be fully invested in equities at all times. If they believe the Dow will close at 13,000 on December 31, can they actually take advantage of that view since they don’t have idle cash to put to work? And if they can’t use their own predictions, why are they making them in the first place?

If we’re right – and neither PIMCO, nor anyone else, can accurately predict the level of the stock market at a certain date in one week, one month or one year – why do so many sell-side analysts (and a few investment managers) make such predictions? And why do we pay any attention?

I will answer my question with a question: Why do millions of people watch professional wrestling, “The Real Housewives” or “Jersey Shore?” It makes for entertaining television.

My hope from this piece is not that you stop watching business television. I certainly watch regularly and I also participate, sharing PIMCO’s views. I think it is a unique medium in which to follow markets and quickly hear a variety of perspectives on important topics.

My hope is that it becomes a little easier to distinguish thoughtful commentators discussing knowable economic topics from entertainers throwing darts.

In conclusion, I will leave you with my very own bold prediction. I am utterly unqualified to make it. I have no information edge nor can I possibly influence the outcome. In addition, there is absolutely no downside to my being wrong. Are you ready for it? “The Cleveland Browns will win the Super Bowl.” You heard it here first. (Note: I didn’t specify in which year.)

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