Expectation vs Reality

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The past couple of years have been full of events that most of us never saw coming — covid, war in Ukraine, supply chain shortages, high inflation, and energy crises. Forecasting what comes after the surprise is hard not only because there’s little precedent, but also because we are prone to overreaction.

Our expectations are extrapolative — overoptimistic in good times and overpessimistic in bad times. This isn't a flaw, our short-term memory is how we make real-time sense of the world. It’s natural to overreact to recent events and project them into the future.

When the bull market was ripping, “Dow 100,000” or “Bitcoin 100,000” was everywhere. And I’m not sure which was crazier.

In February 2021, Anthony Scaramucci went on CNBC and predicted Bitcoin will reach $100,000 when the cryptocurrency was fresh off a 200% gain in the previous 2 months. Later that year in August, Anthony Pompliano started selling “Bitcoin $100,000” hats after it rose 60% in July.

It wasn’t just in the most recent bull market. Back in 1999, at the tail end of the dot-com boom, Charles Kadlec released his Dow 100,000 book. Greenspan would call all of this irrational exuberance.

Perhaps even more pronounced are the negative overreactions. Michael Burry is famous for predicting the subprime mortgage crisis starting in 2007. Since then he’s predicted 8 of the last 1 recessions, calling for an epic market crash at the first sign of trouble. Going back further, famous hedge fund manager Seth Klarman predicted no gains for stocks in the 2010s. This was fresh off the Great Recession that served as the nail in the coffin of a lost decade prior. However, the 2010s turned out to be among the best decades in history for stocks.

In March 2020, at the start of the pandemic, Bill Ackman went on CNBC and gave a dramatic speech proclaiming that "Hell is coming” (granted, this amounted to him netting $2 billion upon closing a large short position). Paul Graham illustrated our reactive tendencies at the start of the pandemic:

Why does the recent past factor so heavily into our forecasts? Recency bias. We assign greater weight to recent events than older ones when making decisions. Instead of processing all of the relevant information, the brain overweighs what is easily available. We don't consider the objective probabilities of outcomes over the long run. And the more surprising an outcome is, the more we rely on our biases.

Recency bias convinces us that a bull market will continue to appreciate and that a bear market is likely to keep falling because we rely on the most readily available knowledge.

Would you invest in stocks after the Great Recession? Many people stuck with cash, worrying that another systemic collapse was around the corner. In reality, investors who waited for the 'right time' to reenter missed out on soaring equity markets.

Take sports. If you ask anyone under 25 who the greatest NBA player of all time is, they’ll probably say LeBron James. Everyone else knows it's Michael Jordan. Out of sight, out of mind. Our answer might change if we see something exceptional. Like Kevin Durant's playoff performance last year when he scored 49 points with 17 assists and 10 rebounds.

That's the problem with sensational events - they distract us from rational thought. An extreme prediction following an extreme event is almost always a case of recency bias. And an extreme prediction seems most convincing during times when the likelihood of mean reversion is often highest.

Will there be a nuclear war because Russia invaded Ukraine? Will there be a recession in *insert random year*? Will Bitcoin reach 100k? The likelihood of any of these events happening is low, but not zero. That's why cynics and promoters alike make a fortune selling fear and exuberance, regardless if the unthinkable happens.

Oil prices have been a huge topic this year, leading to some wild predictions. In the face of Russia's actions in Ukraine, Citi analysts predicted that crude oil prices could fall to $45 a barrel by the end of 2023. Meanwhile, JP Morgan warned that the same commodity could reach $380 a barrel. Extreme event, extreme prediction.

Reversion to the mean is a strong force and true outcomes often lie somewhere in the middle. But that's boring, so we rarely hear about the fact that people usually figure things out in the face of a looming catastrophe. Whether that's bailouts, treaties, competitive forces, or simply working harder.

Making an extreme forecast is a bet that rarely pays off, especially when it's the first reaction to something already severe. Predicting the next financial crisis may lead to glory if it comes at the right time and for the right reason. Any other time? It will cost you money and reputation.

-Sam

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