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Great Expectations
These days, nearly every report on the financial markets begins with a description of the results of a bad guess.
"The bond market is crashing this morning on news that inflation is much worse than expectedÉ."
"Stock prices are rising rapidly today in response to unexpectedly strong corporate earnings É."
Who exactly is it that does the expecting? If the expectors are so bad at expecting, why does anybody pay any attention to them?
For people about to make an investment, or peg the interest rate on a loan, few things are more important than a clear understanding of the rules of Wall Street's expectation game.
There are two groups of expectors: one is paid a nice, steady salary to provide the initial guesses, and then a second group bets the ranch on the direction and magnitude of error by the first group.
Group One consists of economists employed by brokerage firms and trade associations who forecast the outcome of each and every report issued by government and private data collectors. There are dozens of such reports: leading indicators, orders for durable goods, wholesale and consumer inflation, employment data, home sales, retail salesÉ on and on, repeated each month.
Group One forecasts are easy to find. On Mondays, the Wall Street Journal prints a chart of reports due out in the coming week, together with the consensus expectation. In advance of important reports, every financial publication includes the consensus together with minority reports claiming the consensus is all wet.
Group Two, the ranch bettors, is made up of professional traders and big time investors. Each of these considers her- or himself to be an especially wise economist (by experience and ego, not Ph.D.), and perfectly able to outguess the dull-witted (i.e. salaried) Group One.
"No chance CPI will come in that low: look at oil!" "Payrolls will be way higher than those idiots are saying: hell, somebody just hired my brother-in-law."
Group Two places its bets in the days before each report; the more important the report, the bigger the bets. The weighting of these bets leads to some strange market responses to news. For example, last Friday's payroll data were right on expectation (for once), and a strong portent of inflation, which should have crushed the markets.
Instead, it turned out that Group Two as a whole had placed massive bets that the payroll report would be even worse than forecast. On the arrival of merely bad news, but not awful, all the short sellers were forced to buy, and the stock and bond markets put in two of their best days this year.
For civilians (the investing and borrowing public), the crucial rule in the expectation game is as follows: no matter how good you are at guessing the accuracy of the Group One expectations, you cannot ever know which way group two is leaning. Without that knowledge, your dead right guess won't do you the least bit of good.
Big securities dealers have an inkling of Group Two's position because they know what bets have been placed by all their customers. In fact, most of the effort at trading desks is spent trying to figure out what the other desks are doing. Civilians can't compete.
Civilians are able to place productive bets on past trends, both short and long term; able to evaluate probabilities, to bracket likely outcomes, and to develop plans "B" for what to do if wrong.
However, the individual report expectations game should be played only for entertainment, not to make money.
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