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By: J.P. Szafranski Guest Columnist August 23, 2022 0

What if you could see the future? Wouldn’t it be exciting? Or would it be scary? Probably both. It might lead one to hubris or some sort of dangerous fate. Probably best that we leave such a superpower to science fiction, right?

Each of us faces uncertainty about the future at every waking hour. How will my day go? Will I keep my good health? Will the driver behind my car stay off their smartphone? For a business leader, if one can peer just around the corner and correctly predict a future industry trend, there can be tremendous opportunity for profit. It’s the same story for financial market investors trying to assess how economic and industry conditions will affect a security’s future value.

If only it were that easy. To grapple with the reality that we must function in the midst of uncertainty, we use heuristics, defined by Daniel Kahneman in Thinking, Fast and Slow, as “a simple procedure that helps find adequate, though often imperfect, answers to difficult questions.” This works well with low-stakes decisions, like “it looks overcast this morning, I better grab my umbrella.” Experience tells us that overcast skies often lead to rain. If it doesn’t end up raining, I carried an umbrella for no reason. Not a big deal.

In higher-stakes situations, we often get ourselves into trouble when interacting with uncertainty. We combine the use of a heuristic, as adequate though imperfect it may be, with our natural state of overconfidence bias (an over-estimation of our own abilities) to make a reckless decision.

Going back to financial markets, you can see this play out in different ways. “The economy is going to take a turn for the worse and markets are going to crash, sell everything!” “The economy is going to remain strong. Everyone is getting rich in the stock market, I need to add leverage to my account so I don’t miss out!” Either perspective is more than likely to lead to future regret.

Please handle heuristics with care. Don’t overreact. With all that said, let’s look at a couple of macroeconomic heuristics which have been useful to predict prior recessions. You might be familiar with the term “yield curve.” A yield curve simply compares market interest rates of various maturities. Short-term interest rates tend to be lower than long-term rates. This equates to a positively sloped yield curve. When short-term rates rise above long-term rates the yield curve is considered “inverted.”

The Leading Economic Index (LEI), published by the Conference Board includes the yield curve along with a bevy of other macro-economic data points which attempt to predict the future path of economic growth.

Sources: National Bureau of Economic Research (NBER), Bloomberg LP & The Conference Board

Every recession in the modern era has been preceded by an inverted yield curve. As you can see, the LEI tends to flip negative after the yield curve (the table above defines the yield curve as the two year Treasury note yield minus the 10-year Treasury note yield). Where are we today? Well, the yield curve inverted at the end of the first quarter of 2022. Last week, the year-over-year change to the LEI fell to 0.0%. If these indicators were a Magic 8 ball they might say, “Outlook not so good.”

J.P. Szafranski is CEO of Meliora Capital in Tulsa (www.melcapital.com).

This column has been prepared by an employee of Meliora Capital, LLC. This column is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding any security mentioned herein. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable parties may disagree about the opinions expressed herein. The representations made in this column are based upon publicly available information and assumptions about future economic variables which may or may not be reflective of actual occurrences. Meliora Capital, LLC its employees or affiliates may have an economic interest in the securities identified herein.

All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions. This information is provided with the understanding that with respect to the material provided herein, that you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action

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