2009 Outlook—Markets Measure; They Don’t Forecast by David Kotok

December 27, 2009

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).


We are starting this commentary with two quotes that superbly summarize the state of the wealth effect, economy, and the outlook for applied stimulus. Cumberland’s strategy and rationale follow the quotes. We specifically acknowledge the effort of Howard Simons of Bianco Research for his repeated seminal work on how markets measure well and forecast much less well.

“The Federal Reserve Flow of Funds report showed a marked deterioration in the state of household balance sheets in Q3. Household net worth fell 4.7% q/q in Q3, translating to a $2.8 trillion loss in household wealth and marking the biggest y/y decline in the history of the series. Household real estate wealth fell 2.8%, reflecting the sharp decline in home prices… The decline in household wealth was accompanied by a decline in mortgage debt, which fell 0.5% q/q, the first decline since 1983. Homeowner equity fell to 44.7% of household real estate, marking a new record low. Household balance sheets also suffered from a 4.5% q/q decline in financial assets, driven by a sharp drop in the market value of corporate equities and mutual fund shares.”

– December 12, Julia Coronado and Michelle Meyer, Barclays Capital

Followed by this:

“The economy’s recovery depends critically on an energetic fiscal policy by the new Administration and Congress…President-elect Obama…will quickly enact significant stimulus for the economy. This is sure to include major new tax reductions…Also to be included is sizable additional spending on infrastructure, broadly defined to include support to state and local governments for a wide range of outlays.…On the monetary side, the Fed will soon be lowering its official rates close to the vanishing point…Yield penalties on investment-grade securities relative to Treasuries are likely to narrow once the extraordinary pressures created by year-end portfolio “window-dressing” pass, but if they do not, the Fed will broaden further the types of securities it buys…With such vigorous support, retail sales, housing starts, and business inventories may stop declining by mid-2009… even in such an environment of near-zero GDP growth, aggregate profits of non-financial firms (except those related to construction, autos, and, perhaps, oil), may actually hold steady or rise, cushioning the decline in capital spending. Net revenue will be well maintained as labor and import costs tend to decline…”

– December 12, Dr. Albert Wojnilower, Craig Drill Capital

Cumberland Advisors’ portfolio management strategy starts with a few assumptions. In the United States both financial policy engines are at full throttle: they are the fiscal engine (deficit spending of $1.5 trillion or more) and the monetary engine (see: www.cumber.com for the weekly updated description of the Federal Reserve’s balance sheet and programs). As Dr. Wojnilower notes, and we agree, this “vigorous support” is expected to arrest the economy’s decline by the 2nd half of 2009. The Fed’s own forecasts are reasonably consistent with this conclusion; they argue that it is the target of Fed policy to bring this result to reality.

This massive stimulus is applied because there is (1) an extreme negative wealth effect (see the Barclays quote above) and (2) a decline in employment and (3) pressure on incomes. Note how this may not play out into a profits debacle (outside of the financial, housing, and consumer discretionary sectors).

Also note how the appearance of no positive outcome prevalent in many forecasts is dependent on the failure of the two-engine stimulus.

We are on the other side. Instead of saying that stimulus fails and the economy just sinks and sinks and sinks, we are saying that stimulus in this massive amount succeeds and that the economy will stop sinking and plateau. Subsequently it will start to expand as all the pent-up demand begins to convert to spending and economic activity.

We are saying that markets change their pricing because they are forward looking. They usually bottom in the midst of the bleakest outlook and they often bottom BEFORE the economics appear to turn. History shows that over time, financial markets are able to change prices to reflect forthcoming changes in economic data. That is why markets are viewed as leading indicators. They are not forecasting the change; they are measuring the behaviors and sentiment of the investors who are forecasting the change. Markets move as a result of actions by those who are seeing a change earlier than economists can compile the data to demonstrate that the change is at hand.

Financial Markets do NOT forecast well in a strategic sense. If they did the oil futures curve would have warned of $140 oil when the price was $40 and it would have warned us of 40 dollar oil when the price was $140. Markets did neither accurately.

Financial markets measure the present consensus sentiment. They price it every day as folks make their real money commitments. The price tells you what the existing psychology is; it doesn’t tell you what it will be and it doesn’t tell you when it will change. Markets measure; they don’t forecast.

Here are some samples of current measurements that are not forecasts. Readers may judge for themselves if these are market forecasts of doom or if they are measurements of market dysfunction and extremes of psychological damage. Then each reader may decide and act according to his/her own view. In doing so he/she will become one of the many agents that make up the very markets we are measuring. Readers and their actions will be measured along with all the others.

Here is the evidence. You decide.

When the 90-day T-bill trades at zero interest it is measuring something. It does that on the same day that the two commercial banks used by Cumberland Advisors for our firm’s own deposits are paying us over 3% on our cash. Both of those yields are backed by the United States of America. The risk of loss is equally nonexistent. So why are they so different? Because they are measuring two different things: zero interest on US government Treasury obligations is driven by one set of investors; 3% interest is driven by a different set. Each is measuring a unique subset of cash and cash equivalent yields. Market measure; they do not forecast.

You can loan your money to the United States of America for 30 years at 3% and that is a taxable instrument. You can loan your money to a high-grade state credit and get 6% (in some jurisdictions we are getting clients as much as 7%). The tax-free yield on long duration in the United States is double the taxable Treasury yield. Markets are measuring the psychology of fear. They are not forecasting that all states and local governments are going to default.

Those who do not accept this principle that markets measure are doomed to lose sleep trying to understand behavioral malfunction in the realm of sentiment. In dysfunctional market periods like the present one it is critically important to sort through this issue. Each investor has to determine what they are missing when they see an anomaly. Understanding what the market is measuring helps clear up the puzzle. Remembering that markets are measuring and not forecasting maintains the balance while the puzzle is being solved. Here are more examples.

The credit default swap on the State of California is priced higher than the credit default swap on the country of Turkey. Does anyone really believe that the US is more likely to default than Turkey? No disrespect for the Turks is intended. Maybe if California Governor Schwarzenegger had the Turkish parliament instead of his legislature, he would have a budget passed and his credit default swap would be priced differently.

The credit default swap price for the United States is higher than the credit default swap price for Campbell Soup. No disrespect to Campbell Soup. I like it on a cold winter day. But I think the US has a better chance of paying its debt than the soup maker. And both of them use the US dollar to make the payments. Campbell makes soup; I own some cans of it and bought it with my dollars. The US government makes those dollars and has unlimited dollar productive capacity and negligible cost of production or materials.

Markets measure; they don’t forecast. If they were forecasting, they would be saying that Turkey soup is more likely to pay the dollars it owes than is US Treasury and the US’ largest state.

Ok. Let’s sum this up as we approach 2009. We believe the economy will bottom in 2009 and the bottoming will be in the data during the second half of the year. We believe that the stimulus combination of massive fiscal and massive monetary will work. And we are applying that assumption in our portfolio management.

Clients who do not agree with us have asked us to take a more cautious view, and we do so for them. We are a manager of separate accounts. We are not a common fund. Our job is to meet the client’s objectives and not impose our will on the client. If the client asks, we offer what we think is our best guess of the future. If the client wants to be riskless and in US government credit only, we do it.

That said, we are recommending to our clients that they use an asset allocation of 50% stocks and 50% bonds. Cash is at zero. Remember that the classic efficient frontier is 70% stocks and 30% bonds. So we are 20 points under on the stocks side and 20 points over on the bond side. The reason is that bonds are soooooo cheap that they warrant overweight.

Both sides in this 50-50 stock-bond mix are fully invested. On the stock side we only use exchange-traded funds (ETF). We do this domestically in the US, and we do this abroad. And we do this in other asset classes like currencies and commodities and precious metals.

On the bond side we are emphasizing high-grade credits. The junk bond market is very cheap, but it requires a special set of skills and we do not apply them at Cumberland. Clients who use junk bond allocations are using other managers. We are in investment-grade bonds only, whether taxable or tax-free. On that note, our clients are also fully invested and favor longer duration.

As this financial turmoil period enters its third year in 2009, we expect the various sectors to heal and the spreads to narrow. This will occur piecemeal. We already see it in some areas. The results of the application of stimulus by the Fed will be seen sector by sector and will have its own accelerator. Investors who wait until the air has cleared are taking no risk, but they are also not going to get a reward.

Right now markets are measuring extremes in risk aversion by investors. That explains high cash balances and zero-interest T-bills. As each market clears it will gap to another level. It will not trade there calmly and slowly. The lesson to be learned from high-volatility measures like the VIX is that markets can gap. When they do so, an investor sitting on the sidelines has very little chance of getting in. The most money is made in markets when measures of risk aversion are extremely high and then markets turn.

Remember, when you see a parabolic curve you have no way to know when it will stop and turn. You can only learn that after the fact. Most markets today are showing us this parabolic formation. They are measuring extremes at several standard deviations from mean and at record levels, levels that have never been seen before.

I know this statement is redundant; I repeat it for good reason: Market spreads and risk indicators are at levels never seen before. They are measuring, not forecasting.

2009 may just work out to be a good year. 2010 may be even more robust. At Cumberland we want to be in it, not out. Stay tuned.

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok -at- cumber.com


Cumberland Advisors supervises approximately $1 billion in separate account assets for individuals, institutions, retirement plans, government entities, and cash management portfolios. Cumberland manages portfolios for clients in 42 states, the District of Columbia, and in countries outside the U.S. Cumberland Advisors is an SEC registered investment adviser. For further information about Cumberland Advisors, please visit our website at www.cumber.com.

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12 Responses to “Markets Measure; They Don’t Forecast”

  1. rww says:

    You say “pent-up demand” will carry us to shore. What is the data?

    I see no demand anywhere. People are fully sated. The frenzy has passed.

  2. Moss says:

    I believe it was Buffet who said the market is a voting machine in the short term and a weighing machine in the long term.

  3. Keith - Hermosa says:

    I couldn’t help notice this author’s high opinion of California. It is my experience that California is a state full of hot house flowers. There is no tolerance for discomfort here. It is populated by people and the offspring of people whose common priority is avoiding bad weather. A decade ago Orange County, a very rich county, decided that rather than pay for it’s spending with taxes, it would be better to gamble a fortune on get rich quick investing. It went bankrupt.

    Now California is out of money and I have little doubt that the citizens of California would rather go bankrupt than pay taxes. This is a gaping hole in the commentary above. When I see holes like that I have to question the whole of the argument.

  4. geckoman says:

    LOL…he’s an asset allocator, a believer in efficient market hypothesis and all things Harry Markowitz. He’s staring a train down not even knowing what he’s looking at. Someone please step in and help his clients out before he bankrupts them.

  5. ben22 says:

    To note, this was written it looks on 12/27,

    the discussion of tax free bonds should clarify that now, many of those bonds are not as he states:

    sooooo cheap

    they have, in many cases, had a huge run already this year, so yes, that was a good call.

    Also they say this:

    Investors who wait until the air has cleared are taking no risk, but they are also not going to get a reward.

    They also aren’t going to take a potential still coming pounding.

    Come on. The market certainly appears that it could easily re-test the 11/21 prices, we could call that fear as well, and perhaps go further below on to 7k on the DOW or into the sixes. Joe Six Pack hasn’t sold what little he has yet but that could be coming. Another tax problem, another ponzi, another bank issue, where is the confidence, and thus the marginal buyer going to come from?

    So if I were to assume that we drop, 12% for example on the DOW from where we are today, not unreasonable, then his clients will need then 18-24% on the equity side to get back to break-even. I’ll give you the benefit of thinking some of your equities won’t drop as much as the market if it drops that 12%.

    Mr Kotok,
    Do you really think that when we do in fact get out of this, second half or not, that the DOW is just going to shoot back up quick enough to provide your investors those returns? Maybe you just expect to pick all the correct sector ETF’s.

    I hope it works out for you, and more importantly for your clients.

  6. Bruce in Tn says:

    I am about to go run, but I will share this with the folks.

    I went back to my hometown this August to attend a folksy festival that some of the folks who stayed there after high school have started to give yearly…while at a party, my wife and I ran into some folks who are in the investment business, in a medium-sized firm. This man, not one of my favorites, came over to listen to a discussion I was having with a small businessman in the town, and I was giving my opinion to him that times were going to get tougher, and that I planned to be cautious for awhile. My ex-classmate interrupted and said that “Now is the time.” That even Warren Buffett had opined (and he had) that things were going to get better…

    Well, here we are a few months later, and I don’t know if Vince listened to him or me, but I think my ex-classmate’s clients are probably none too happy with him now…but who knows…

    I talked with Mark, one of my partners this morning, and he hasn’t sold any stock in his retirement portfolio…I asked him why not, and he unfortunately has drunk the “it’ll turn around” kool-aid, that his investment advisor has him on since January of last year…

    Oh, well. Down 55% and still hoping for the best….

  7. Thisson says:

    The guy has a point: be greedy when others are fearful.

    However, I *do* think California has a higher change of defaulting than Turkey does.

    And I do think Campbell’s Soup is more fiscally responsible, and more likely to pay off all its debts in full, than the U.S. Government (even if the repayment is in devalued U.S. dollars).

  8. John Borchers says:

    Very good stuff. He’ right if they forecasted they wouldn’t get it wrong on the high side and low side. They would be in the know, and they are not.

  9. Ken says:

    Kotok appears to have two different claims here, or rather, two different levels of claims. At the “theoretical” level, his big thesis is that markets do not forecast. From that premise (or at least, using that premise in justification), he has a bunch of “practical”-level claims about Turkey, California, and Campbell’s Soup. In the comments so far, there’s more about the lower-level stuff, but what do people think of the thesis that markets are non-predictive?

  10. ben22 says:


    I don’t disagree at all the markets are non-predictive, I like the way he says it though, we hit a record on the DOW 2 months before the recession started. It is, to me, a very valid thesis.

  11. what do people think of the thesis that markets are non-predictive?

    I think both AAPL and GOOG stock prices have done very well at predicitng the success of their franchises and products. They have shown that the price of the stocks are far from perfect but GOOG is a great example showing how a stock’s earnings can grow into the extreme valuations that investors place on them. That being said I put a strong emphasis on the mechanism being far from perfect. It is not non-existant if you ask me and due to the irrationality of and the ability to irrationally pump crowds I wouldn’t bet blindly on it.

    I would probably give less predictive credence to indexes due to the nature of their dominant participants. That being big institutions and funds that have a long term investment horizon. Because they are very much controlled by flows of funds they tend to diminish the predictive nature of the markets some in favor of more efficient market timing

  12. Groty says:

    Markets do measure sentiment. They are also a source of liquidity.

    Valuations and sentiment are irrelevant to market participants who are forced to sell assets either to meet margin requirements or redemption requests by their investors. While it’s true this forced selling often creates values, investors may be reluctant to provide a bid if they believe the forced selling will continue. That lack of buying in the face of forced selling drives prices even lower. We saw alot of that in 3Q and 4Q last year, when $600 billion was redeemed by hedge fund invesors.

    Morgan Stanley expects hedge fund assets under management to decline another $450 billion this year through a combination of market losses and client redemptions. If true, that is a tremendous amount of selling pressure at a time when investors continue to be concerned about the future of the economy and ’09 corporate earnings estimates are still too high.

    I suspect the “bargains” you believe you see today will become even better bargains in the next couple of months months.