Sussing Out Probabilities


Why are markets rallying and/or falling every other day? They make gains only to give them back, or they sell off hard only to subsequently regain the losses.

I suspect it is because the dispersion of likely future outcomes is so unusually wide. Meaning, what investors imagine as the most likely outcomes are all over the map.

Perhaps a weather analogy may help explain: Since its October, let’s imagine a typical weather report: 80% chance of sunshine, with a slight chance of showers overnight, daytime temperatures of 60-67 degrees, dropping to 52-60 in the evening. If you were going away for the weekend, you would have a pretty good idea of what assortment of clothes to pack for that trip.

Markets are like this much of the time: The economy has been doing okay, earnings are pretty good, inflation is modest, the overall trend has been upwards. In this environment, it’s a pretty safe bet to guess that you’re gonna end up somewhere close to the historical averages – total returns of 6.7% real (8-9% nominal). This is especially true if you’re looking at longer time frames.

But imagine you got a very different forecast: 40% chance of 80-degree sunshine, 30% chance of tornado, 20% chance of blizzards, and 10% chance of a torrential downpour. How do you pack your small carry-on bag for that weekend?

The answer probably is you don’t want to go on that trip.

Markets do not have the choice to sit out a bad weather forecast. Hence, they have been behaving as if we are in more of the latter set of circumstances than the former. The possible outcomes seem to be widely dispersed across a broad range of possibilities, from deeply negative to strongly positive, each of which seems to be more or less equally likely:

– Earnings strength (weakness) cause market to rally (sell-off);
– Sticky (transitory) Inflation leads the FOMC to tighten (pause);
– Worse (better) oil supplies send prices higher (lower)
– A too-aggressive (modest) Fed leads to a painful (mild) recession;
– Midterms (don’t) provide clarity and elections are (challenged) certified;
– Budget passes (standoff) and the government is funded (shut down);
– Russian invasion of Ukraine spirals (ends) with catastrophic (positive) consequences;

When inapposite outcomes have similar probabilities of occurring, every new piece of news (no matter how marginal) takes on an outsized significance. Hence, each new tidbit gives active allocators of capital paroxysms.

I have been increasingly constructive on these markets, but I am also very aware that off in at least one possible future, there is a flow of data, news, and events that are all very negative for stock prices. It is just as possible that there is another future market that shakes off the flow of bad news and rallies despite (or more accurately because) of it.

I am fond of saying the future is unknown and unknowable. But when the full range of possible outcomes is this challenging to assess, it makes the markets appear flighty, indecisive, and trendless.

Nobody ever said discounting future cash flows was easy…



Groping for a Bottom (October 14, 2022)

7th Inning Stretch (September 30, 2022)

Countertrend? (August 15, 2022)

One-Sided Markets (September 29, 2021)

End of the Secular Bull? Not So Fast (April 3, 2020)


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