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Wed Jan 11 10:43:02 PST 2006

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PREDICTING THE UNPREDICTABLE
Jan 10th 2006  

Who needs forecasts? What we want is certainty

THE season for making predictions is coming to an end. According to
most analysts we are set for a year of robust equity markets, with the
Dow Jones Industrial Average, which passed 11,000 this week, ending up
at around 12,000 and the S&P 500 at 1,400, while the FTSE 100 and the
Dax 30 are generally expected to rise to around 6,000 and 5,800
respectively. The euro and the yen will strengthen against the dollar,
but not dramatically, while inflationary pressures will force dollar
and euro interest rates to rise by a percentage point or so.

Most investors apart from day traders have already decided how to
allocate their assets in 2006. Buttonwood can only warn them what
earth-shattering events might jerk prices up and down between now and
2007 and knock their carefully identified trends off the screen: for
example, a Middle East crisis that redoubles the oil price, or a
breathtaking free-fall of the dollar or the Dow. We have seen such
things before and we are bound to see something like them again. Prices
never go where they are expected to. Benoit Mandelbrot, who created
those lovely fractal designs with "chaos" equations, regards
markets--like plants and coastlines--as successions of self-similar but
endlessly complex patterns. Prices are as likely to go to 1,000 as to
zero, he said in a recent interview.

Seen through those eyes, market forecasts are essentially futile; and
they are many times more likely to be wrong than right. But that
doesn't prevent more or less every analyst at every brokerage firm or
bank from giving his pennyworth at this time of year. It's what's
expected of him.

Hats off then to Norbert Walter, chief economist at Deutsche Bank, for
going completely off the rails and writing about himself, and his
theories on managing a team of bank economists. "Good management
requires individuals that employees can look up to as role models.
Dedication at work is not enhanced if the boss is often late, loves
'meaningful' breaks and does not meet his deadlines...He should use
strong verbs and clear sentence structures and thus be a 'style guide'
for his employees."

Most analysts, though, stick to predicting where the Dax or the Dow
will be in 12 months, along with the main interest and exchange rates.
They have very plausible arguments. Indeed, it is comforting to make
believe that the world will progress in linear fashion for the next
year. But plausibility is no substitute for certainty.

Naturally, investors want as much hard information as they can get so
that the outcome of an investment decision is as certain as possible.
One approach would be insider dealing: the achievement of
near-certainty by other means. But Buttonwood does not want to
encourage such transgression. Even so, he might be able to offer
readers some near-certainties for 2006.

For example, it is a sure bet that the volumes of over-the-counter
derivatives, interest-rate swaps and options, currency swaps, equity
derivatives and credit default swaps will continue to rise over the
next 12 months, as they have done since their invention (see charts).
It is also near certain that the volume of mergers and acquisitions
business and private-equity investment worldwide will continue to rise
in 2006.

Banks preparing for the introduction of new capital-adequacy rules
(Basel 2) in the European Union and other parts of the world in January
2007 will continue to favour higher-grade credits over riskier ones.
That is bad news for smaller, higher-risk companies, which are already
feeling the pinch because of declining investor demand for high-yield
debt.

Another near-certainty is the continuing flow of investments into
global equity and bond funds. It seems there is no mechanism available
to check this wall of money, with its tendency to keep investible asset
prices unnaturally and perhaps irrationally high. Hence, too, the
enormous demand for gold and works of art. A correction is bound to
come, but telling when and where is probably a job for analysts at the
beginning of 2007.

Meanwhile, there is potential to make money from some of the more
predictable events of the coming year--for example, from a handful of
sporting fixtures with almost certain outcomes. Call any good bookmaker
and put your money on Oxford to win the Boat Race on April 2nd, Roger
Federer to win Wimbledon on July 9th and, if you will forgive
Buttonwood's bias, England's cricketers to retain the Ashes in
Australia on or before January 6th 2007.

More seriously, some or all of the following events are likely to
happen in 2006, and those who have access to financing from prime
brokers could get themselves into position now, if they have not done
so already.

First is a fresh accounting scandal in America. The question, of
course, is to identify the particular company and its cowboy reporting
standards, and to short the stock. Suggestions unfortunately risk a
libel suit.

Second is a foreign takeover of a large Italian bank. Take your pick
from Banca Intesa, Capitalia, or even the sui generis predator
UniCredit--and then find some pessimist to sell calls on the stock.

The third likely event is a merger of at least two big European stock
exchanges. There are only three to choose from, and each is engaged in
ritual courting of the other two. Most canny punters already have
stakes in all three, bought at last February's prices.

So much for the money-making opportunities. Sadly, Buttonwood cannot
rule out some nasty possibilities, such as a disruptive terrorist
attack in a European city, an epidemic of avian flu in Europe or
America, another bad hurricane season or an earthquake on the Pacific
rim. Financial markets have been remarkably resilient faced with this
kind of event. Against a common adversity--the disruption of traded
markets--all sides seem prepared to work together. The danger, however,
is that several events coincide with, say, a loss of confidence in the
dollar, or the collapse of a company involved in global markets. Robust
though the financial system appears, it has been tested recently only
by operational disruptions that lasted a few hours or days, not by the
threat of widespread insolvency.

All the more reason to wish for the forecasts of a reasonably peaceful
and prosperous year.

- - - - - Send comments on this article to Buttonwood (Please state
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Read more Buttonwood columns at www.economist.com/buttonwood[1]

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