Know Way!

"It ain't what you don't know that gets you into trouble , it's what you know for sure that just ain't so. "

Josh Billings.

After rising to new highs, global financial markets seem pretty sure of themselves. The future must be pretty bright, based on the rally. But how can we be sure they have got it right? What do they know that we don't?

Daniel Levitin is one of my favorite cognitive neuroscientists. Actually, he's the only one I know but he is an interesting guy. His book "This Is Your Brain On Music" is a great read, especially for wannabe musicians like me.

I'm now reading his recent book, "Weaponized Lies - How to Think Critically in the Post-Truth Era".

In it, he describes the cognitive mistakes that we as humans tend to repeatedly make when evaluating information. He argues data can be used or misused depending on what people think they know. And people always think they 'know' what they know. But what exactly do they know?

There are four risk assumptions embedded in every financial market. Three of them are VERY hard to forecast.

1) Known knowns - The Risk Free Rate is 1.55%; S&P500 Forward PE ratio is 18.5X and the ERP is 3.9%. Easy.

2) Known unknowns - Central Banks are suppressing interest rates - but for how long? This is why Fed watching is popular.

3) Unknown knowns - What will the exploding levels debt and deficits mean? We know this is happening but not many are talking about it - and they should be.

4) Unknown unknowns - What will investor risk tolerance levels be in the future? Or more simply put - how do we anticipate the anticipations of others?

It's the last one that is most difficult to evaluate and yet market analysts never talk about it. Who knows what market participants expectations will be in six months? Those expectations will be based on interpreting future economic and geopolitical data that are inherently unpredictable. More importantly, it is also a function of the 'spin' that data will be given. But this is the crux of any forecast of future stock market returns. That's why anybody who thinks it is easy - is stupid.

I have always tried to approach markets by attempting to guess future state of risk tolerance - the hardest task. This is why investor expectation data (like the AAII Survey, Commitment of Traders, and Implied Volatility measures) are important to me. I don't always succeed, but I find it fun to try.

Human nature is rife with bias. Given how little we 'know' for sure about the future and much can go wrong with the forecasts, it is no wonder passive investing continues to gain share.

Shows what I know.

Risk Model: 3/5 - Risk On

The Canadian market is 5% above it's 200 dma - comfortably below the negative signal condition of 10%. Unfortunately, global risk tolerance is usually shaped by the U.S. markets.The S&P 500 is now 10% above the 200 dma. - over it's skis for sure. Caution lights are flashing.

AAII Bull/Bear Ratio is likely to bounce back from last week's short-lived risk-off shock as the Copper/Gold ratio has already done so. I bought more copper stocks this week.

3 Mo VIX

The low level of implied volatility is remarkable, given both the elevated geopolitical risks and impending earnings reporting season. Seems people 'know' that things are gonna be alright.

Nothing to see here - move along.

Yah sure.