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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