Over the next two weeks, Australia will see the running of the Melbourne Cup and the United States will elect a new President. We can confidently predict that a horse will win the Melbourne Cup and that a human will become President.
Forecasting and predicting are often inter-mixed in commentary. However, they are arguably different activities and the reliance on forecasting and predictions, without understanding their difference, can lead to poor investment decisions and outcomes.
The ability to forecast and to predict the future has varying degrees of difficulty. It is this difficulty that is reflected in betting markets. The more predictable or likely an event is, the lower the betting odds will be. For instance, in the Melbourne Cup, you should not be able to bet on the prediction that a horse will win the Cup. No one will take (or lay) that bet unless it is priced like a Japanese bond. That is – “I will take your $100 bet and give you back $99 if a horse wins the Cup”. Who of us would not take that bet? But who in the world would make that bet?  Well, maybe a bond manager!
You may be able to have a bet that the race will be called off or abandoned. The chances of this happening are extremely low, hence the betting odds will be extremely high – but it is possible. However, it is neither a forecast nor a prediction. It is pure speculation, but there may be a need to hedge a position for a “black swan” event. The Victorian Racing Club has no doubt taken out insurance to cover a catastrophic event occurring on Cup day and that is called insurance.
In the capital markets, it is prudent at times for asset managers to hedge portfolios by taking out portfolio insurance. Such insurance, mainly structured through options or derivative markets, can protect portfolios against catastrophic events. The cost of this insurance varies as market participants wax and wane between optimism and pessimism. Indeed, it is often the case that consensus feelings dictate the cost of insurance, leaving it to the dispassionate trader to pick the mispricing of risk where consensus behaviour outweighs logical behaviour. The dispassionate trader is akin to a bookmaker in the Melbourne Cup.
Wrong forecasts
Source: Hedgeye
The US Presidential election is a two horse race. The possibilities for the result are therefore fairly limited. One of the candidates will win and the other may not accept the result. We have reviewed various betting websites and note that there is gender betting. Will the next President be a woman or a man? A “gender bet” should have the same odds as a “candidate bet” unless we are missing something in this election.  So if there is any difference in odds for the candidate winner and the gender winner, there would an arbitrage opportunity for a quick trader.
Source: Hedgeye
Today, the betting markets on the US election suggest that Hillary Clinton is a 90% chance to win the Presidential race. Meanwhile, the possible outcomes in the US Senate are subject to much conjecture – it is noteworthy that a third of the senators are up for re-election, and two thirds of these are Republicans. While a clean sweep of both houses for the Democrats is not expected, it is a real possibility. There is a full election of the House of Representatives, and it is likely that the Democrats will take control of this chamber.  A clean sweep by the Democrats would certainly upset Wall Street, with taxation changes their highest concern, perhaps followed by pharma companies and gun manufacturers and retailers. Investment markets would be perfectly happy if the current gridlock within US politics endures, thereby preventing controversial proposals having much chance of becoming enacted into law. Many asset managers will be considering taking out insurance against the possibility of either a Clinton clean-sweep or a “Prince of Penzance” Trump victory. Last year, Prince of Penzance won the Melbourne Cup at 100 to 1, and became the third horse to do so, starting at those odds, in the last 100 years.
The above may seem like a ramble, but it helps develop our view on forecasting and predictions. Forecasting should be undertaken in context. Forecasts should be positioned as a range of possible outcomes that are affected by a range of identifiable factors. Forecasts should be presented with their underlying assumptions. For instance, we forecast the $A, and we do so based on our underlying views of commodity prices and interest rate settings across the world, and with an understanding of how those factors impact the currency.
Predictions should not be fluid or presented as a range of possible outcomes. They should be based on indisputable facts or factors that are unlikely to change. Predictions should have a higher likelihood of occurring and should only be upset by the so-called “black swan” event. Investors need to be wary of predictions and be careful that they are not misrepresented as forecasts.
A final point on predictions and forecasts is the observation of how betting markets are being set on tomorrow’s Melbourne Cup. The interplay between predictions, forecasts and sentiment is interesting to observe. To begin there is betting being undertaken on the Cup and there are already favorites identified to win the race. The favorites have been promoted by bookmakers whom actually intend to lay the favorites and every other horse that runs in the race. They wish to set odds that guarantee them a high chance of winning. Whilst there are form students or professional punters who do their own research and will bet heavily tomorrow, the majority of betting in the Cup will be by one day punters. The mix of bookmakers setting favorites, media experts making “predictions” and one day punters participating ensures that the Cup betting markets will be unfair to the untrained eye.
It is quite predictable that by post time the favorites will be engrained into the betting thought process of most punters. Many one day punters will look at the odds and let the market price dictate their betting decisions. In some respects the favorite in the Melbourne Cup will be set by a popularity contest stoked by media commentary and bookmaker rhetoric. The issue is not that the favorites can’t win but just that the odds on offer will probably not reflect value. It is easy to liken the prices of Melbourne Cup runners to equity stock prices..
The market price for a security, like the price of a Melbourne Cup runner, may have little to do with their fundamentals. That in our view is both the risk and the opportunity of investing. It is the ability to observe that a share price represents an opportunity rather than a correct view of value that gives an investor the opportunity to make a reasonable return. However, that return is unlikely to be achieved in 3 minutes but rather it can take years.
Oh we almost forgot the View’s Cup tip. Yes we can predict that a horse will win the Cup and we can confidently forecast who will be the favorite based on good track conditions on Tuesday (Jameka or Hartnell). But as to tipping, forecasting or predicting the winner – we have no idea.
Cup day field
Source: Google Images