Forward Looking and the Discounting Theory

“The market looks forward, not backward.” I freaking hate that saying. GO AHEAD AND LECTURE ME about how the market is a discounting mechanism. I’ve been through quite a few classroom lectures while getting my degrees in finance. Additionally, I have given some lectures as an adjunct professor where I had to discuss this as part of foundational finance curriculum. I understand the discounting theory and the math involved. However, the statement is grossly misused and misunderstood.

If you like it, go ahead and use it. But I wonder how anyone benefits from it. Does it help avoid losses? Does it guarantee gains?

When something good happens, it is immediately in the past. Yet, many people look fondly on the past. When something bad happens, it is also immediately in the past. However, it is not irrelevant. You can choose to ignore it at your peril. And I suggest that you can ignore it successfully today, if you were able to forecast it accurately 6 months ago. Why six months? It’s relatively arbitrary, but today I heard some smartie use this line and say the market looks forward by 6 months, so 6 months it is.

Today, when investors are bidding up UBS 14% because it supposedly put $19 billion of writedowns behind it, can you say for certain that 6 months ago you forecasted today’s loss? If you did, then go ahead and ignore it. If you are now looking forward with certainty that there will be no more writedowns from the $31 billion in mortgage-backed securities still sitting on UBS books, then ignore it. I have no idea how to do that but if you do, you have every right to keep repeating that markets look forward, not backward.

Does the market discount optimism as well as it discounts negativity? Listening to the bulls, you will likely come away believing that any discounting of a bad economy or bad corporate profits in the future is irrational and excessive and flat out wrong. How many times in the past 6 months have you heard that the worst was behind you? Or that the banks wrote down more than they needed to?

Here’s the key point. The market should look backward. It should try to learn from the failures of its previous attempts to look forward. It should also try to learn from the successes of its previous forward estimates. The market DOES look forward. That’s a given. But it does not do so with the accuracy that the statement implies. Sometimes the market looks forward and fails to see the dangers in front of us. We’ve done that 6 months before the market peaked in 2007 and 2000 and at many times in history before a crash or bear market.

The market DOES look forward, but in this recent decline, there has been a constant attempt since it began to look forward to happy days. Except for me and a few other people criticized for being negative, most market participants did not look forward with accuracy about market risks before this decline. The market did not look forward accurately a year ago or 6 months ago. I have no belief they are looking forward with accuracy today.

Now that today’s big rally is over, it is in the past. Are you looking forward?

Comments

[p2pvoice]

Great comments, professor!

I also wonder if market looked FORWARD - and forecast - the the dotcom meltdown 6 months prior to it ;)

[Shorewood]

There is a bit of illogic, here. If everyone could forsee a collapse six-months in advance, then the collapse would happen at that time, not six months later.

Ditto, of course, for an upturn.