One of the most common cognitive tricks we play on ourselves is our tendency to explain what just happened with a story line that seemingly makes sense out of randomness. Nothing ever just “is,” and we fabricate a comforting tale that (of course!) accounts for the latest events, making it possible for us to imagine we know what is going to happen next.
This can lead to trouble when it comes to markets. All too often, reality begs to differ. To wit: The post-election rally as an example of just that sort of story-telling.
Recall on election-night as the so-called impenetrable blue wall (another narrative fantasy) in the Midwest developed just enough cracks in Michigan, Wisconsin and Pennsylvania to let Donald Trump sneak into the White House by the narrowest of margins. Despite the closeness of the polling heading into the last few days of the campaign, global markets seemed unprepared for that outcome, and fell as much as 5 percent on the news. Overnight, futures on the Dow Jones Industrial Average were down 900 points. The after-the-fact explanation was that Trump was going to start a trade war or a currency war or an actual shooting war, any of which would be bad for business and corporate profits.
But before the markets opened in the U.S., futures reversed. So, the after-the-fact explanation required a rewrite. These three were the front-runners that accounted for the turnaround: a) a big infrastructure stimulus, b) big tax cuts, and c) broad deregulation for banks. U.S. markets took off, rallying more than 6 percent during the course of the next month. But since then, U.S. equities have traded in a fairly narrow range.
Given all of this, I have my own after-the-fact explanation: uncertainty, although not in the way you’ve been conditioned to think about it based on the widespread misuse of the term by too many market pundits and commentators. A more appropriate definition of this concept probably can explain the market’s shift in sentiment.
We have addressed the issue of uncertainty before (see this, this, this and this); indeed, my very first Bloomberg View column was on the subject of why uncertainty is a necessary driver of markets. For today’s exercise, let’s use Credit Suisse strategist Michael Mauboussin’s explication of the difference between what is unknown and what is uncertain.
It’s something like this:
Unknown: We don’t know exactly what any specific outcome might be, but we do know the data set we are working with -- the range of possible outcomes is limited.
Uncertain: We don’t know exactly what any specific outcome might be, and we also have an open data set -- many outcomes are possible. The data set is unknown and unknowable.
For money managers, the difference between these two matters a great deal, as it significantly affects how they determine what the risk of any given investment or market or environment might be.