Sunday, March 15, 2020

Markets Don't Hate Uncertainty

Markets don’t hate uncertainty.

Markets aren’t sentient beings with feelings. It is much more meaningful and accurate to say markets price uncertainties and risks.

As uncertainty rises, markets adjust prices to reflect that information. As risk tolerance changes, markets adjust prices to incorporate that as well.

The current financial environment gives a helpful, extreme example. Lower prices for stocks are likely reflecting two things: increased risk aversion (higher discount rates) and greater uncertainty about future wealth creation (lower earnings/profits, lower quality of life).

Let's look at each of those causes. First, increased risk aversion: If the average person is becoming more fearful of the future, the rational response for them is to increase how much they value a dollar today as compared to a dollar tomorrow. Technically this means they discount the future by a higher rate than previously. They are raising their discounting rate in the formula:

Money Today = Money Tomorrow less a Discount
$0.90 = $1.00 minus $0.10

[slightly more technically]

Money Today = Money Tomorrow times a Discount Rate
$0.90 = $1.00 * 0.9
(even more technically, 0.9 is approximately a 11.1% discount rate)

If our previous discounting rate was $0.05 for every dollar tomorrow and now it is $0.10 for every dollar tomorrow, then the current value of that future dollar has declined $0.05. Prices today on that future dollar fall from 95 cents to 90 cents.

Second, greater uncertainty about future wealth creation: If the average person thinks that future generation of wealth is going to be less than previously thought, the rational response is to lower their expectations for the future. They are lowering the expectation of money tomorrow in the formula:

Money Today = Money Tomorrow less a Discount
$0.90 = $0.95 minus $0.05

If our previous expectation was to generate a full dollar tomorrow and now we fear tomorrow will only see the generation (creation) of 95 cents, then prices today on that future amount fall from 95 cents to 90 cents.

What happens when both happen at the same time? We then would see a compounding effect in prices today. 

What was once
Money Today = Money Tomorrow less a Discount
$0.95 = $1.00 times 0.95

Is now
$0.855 = $0.95 times 0.9

Prices for money today have fallen $0.095 ($0.95 - $0.855) or 10%.

These are the underlying forces that drive the more complex world in financial markets. Investments in equities (stocks) have fallen significantly in the past month. This is very likely an example of both increased discounting of the future (greater risk aversion) and lower prospects on future wealth creation (lower expected future earnings). The market isn't hating the uncertainty about how risky the world is or what future earnings will be. Rather very appropriately the market is repricing the expected value of what the future will be. 

In every moment that passes new information is revealed about the world. This information is an update to all the prior expectations we had. Some of those expectations get confirmed. Some of them get rejected. But that is too binary a way to look at it. Don't think about right and wrong in terms of predictions. Think about constant adjustment. When substantial new information comes to light like when a virus comes into the world, the virus becomes abnormally very serious, and a pandemic emerges, big adjustments to prices today on values tomorrow naturally and appropriately result. 

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