The "Uncertainty" Discount

Thursday, February 02, 2006 | 05:28 AM

I'm thinking about adding a category called "The Philosophy of Markets." Why? Because I frequently read statements that are just philosophically incorrect, and can lead investors down a wrong line of thought.

Case in point:  An article by the otherwise sharp Mark Hulbert on uncertainty (Profiting from the uncertainty discount).

Ask your self these questions:  What is "Certainty?" How about "Uncertainty?" Where does "Probability" fit into the investing schema? Just a little deep thought about these questions goes a long way in understanding the nature of risk and probability

I long ago concluded thay the Wall Street aphorism "The Market Hates Uncertainty" is a canard. 

Hulbert makers a different point about uncertainty in this discussion:

Dan Seiver is [emeritus professor of economics at Miami University of Ohio and currently a visiting professor of economics and finance at San Diego State University and the University of San Diego].

Seiver points out that, in focusing on whether Bernanke will or will not do this or that thing, it has become too easy for us to overlook the impact that the sheer uncertainty is having on the markets. After all, as any market theoretician will tell you, markets crave certainty. It therefore is a safe bet that the stock market currently is lower than it would have been if Alan Greenspan had somehow been able to continue as Fed chairman. (emphasis added)

I find this statement inaccurate, and for many reasons, and on multiple levels.

Markets are all about uncertainty, and how to apply a future discounting method to it. Without uncertainty, there wouldn't be a buyer for your sale and a seller for your buy. Any certainty implies that the future is definitetively understood and known -- therefore, we can figure out precisely what its worth.

The closest I can come to a statement of certainty is that the Federal Government will not default on their credit obligations to repay U.S. Treasuries. That certainty is worth about 4.5% a year, in the form of a 10 year bond. Thanks to the flat yield curve, the two year duration yields about the same return, witht he one year a smidgen behind that.

Any attempt to generate returns over that amount -- 4.5% --  is defined as the reward for taking on uncertainty.    

Indeed, the only times Markets are "certain" seems to be at tops and bottoms. In Q1 2000, the markets were certain that valuations no longer mattered, that new metrics applied, and that stocks would continue to grow forever. Indeed, tops can be defined as a period when uncertainty is replaced with a false certitude, when everyone is bullish and long, and there are no uninvested buyers left to come in and take markets higher. We have both certainty, and uniformity of belief.

At bottoms, a dollar is only worth 75 cents, the baby gets tossed out with the bathwater, and everything goes to hell because investors are certain we are going to go much much lower.

Since the future is unknown, it is by definition uncertain. And as we have seen, forecastors (present company included) have proven to be notoriously poor at prognosticating the unknown.

But given Professor Seiver's view, how might this so-called uncertainty manifest itself? Why, by making stocks underowned, and therefore potentially be a bullish play! (Of course! Why didn't I think of that!)

Hulbert notes:

One implication of Seiver's analysis is that our exposure to stocks right now could be somewhat higher than it would be otherwise. That's because, as Wall Street gets to know Bernanke and his actions become more predictable, the market's uncertainty discount gradually will evaporate.

Huh? How uncertain will Bernanke's actions be? Its not like Vladimir Putin took over the Fed. The Federal Reserve will raise rates either nonce, once or a few more times. Historically, the odds favor they will tighten a bit too much in their quest to stop inflation.

Further, probabilities are that when they are done tightening, the markets will be lower 6 months later (71% of the time) and 12 months later (64% of the time).


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With this post, I am adding the category "Apprenticed Investor." In the future, whenever I come across a concept I want to address in that series at the Street.com, I will also use this tag . . .

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Source:
Profiting from the uncertainty discount
By Mark Hulbert, MarketWatch
Marektwatch, 12:01 AM ET Feb. 1, 2006 
http://tinyurl.com/afw95

Thursday, February 02, 2006 | 05:28 AM | Permalink | Comments (24) | TrackBack (1)
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» A New Era:Nervous about Helicopter Ben from A L E A
Bernanke is now the new Fed ChairmanSince his nomination => dollar up , gold up more than 20%,shaky markets,the removal of uncertainty [the nomination] hasnt been helpful.I suspect that the believers in continuity are missing... [Read More]

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Comments

I have always wondered about that certainty thing. It never really made sense to me.

Posted by: DG | Feb 2, 2006 7:36:55 AM

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