The Uncertainty Principle in Markets

As an investor, what do you prefer: certainty or uncertainty?

Certainty, of course. We all do.

When things seem certain, the future looks bright and we embrace risk-taking. When things seem uncertain, it’s hard to imagine things ever getting better, and we shun risk at all costs.

But is there really such a thing as a certain environment when it comes to investing? No. There is always a risk in markets, even if you can’t see it, and by extension, there’s always uncertainty.

It is only our perception of risk that changes.

If the recent past is a calm market filled with good news, we perceive things to be quite certain. If the recent past is a volatile market filled with bad news, uncertainty is deemed to be high.

How are investors feeling today?

Quite certain.

Volatility over the last year has been lower than any period in history.

Image of 12 month volatility vs 12 month return of S&P 500

At the same time, performance has been well above average, leading to one of the highest risk-adjusted return environments we’ve ever seen.

S&P 500 rolling monthly return and volatility from 1928 to 2017

Naturally, investors are feeling pretty good about all of this, with one measure of sentiment (Investors Intelligence) recently hitting its most extreme level since 1987.

Image of Investors Intelligence Sentiment

A summary of the prevailing thinking today is as follows:

  • Recent economic data has been strong -> it will continue to be strong, there’s no risk of recession.
  • Earnings have been strong, are at new highs -> there’s no risk of a slowdown in earnings growth.
  • Tax cuts are coming -> that will have a dramatic positive impact on growth and earnings.
  • Global Central Bank policy remains extraordinarily easy -> that can only be good for markets.

Let’s address each of this from the standpoint of certainty about the future.


The economic data has been pretty good this year:

  • Unemployment Rate at its lowest level since 2000.
  • Jobless Claims at their lowest level since 1973.
  • 85 consecutive months of payroll growth, the longest streak in history.
  • Manufacturing sentiment highest since 2004.
  • Consumer Confidence highest since 2000.

We’re clearly not in a recession today. But does that mean there won’t be a slowdown or recession anytime soon? No. Most economic data (ex: payrolls, unemployment rate) are coincident to lagging. Even data that has leading tendencies historically (ex: ISM Manufacturing, Jobless Claims) only lead by a few months. What this means is we have very little visibility into how the economy will look even a few months from now, let alone a year from now.

The risk here is that some of the recently strong data points will begin to weaken, calling into question the belief that there’s a zero risk of a slowdown or recession. If you think that can’t happen, take a look at every prior cycle. By definition, weak data is always preceded by stronger data.


Earnings this year have been unquestionably strong, recovering nicely from the “earnings recession” of late 2014 through early 2016.

S&P 500 operating EPS growth image from 2010 to 2017

In the third quarter, both operating and as-reported earnings hit new all-time highs for the first time since 2014.

Quaterly Operating EPS and Reported EPS of S&P 500 from June 2010 to June 2017

Does this mean that earnings will post similarly strong results in 2018? It’s possible but unlikely. The strong earnings growth over the past year was due in large part to comparisons with lower levels coming out of the earnings recession. Earnings growth is already down to 10% year-over-year from 21% in the 4th quarter of last year. Given nominal GDP growth of 4% and historical earnings growth of 6% for the S&P 500, expecting earnings to jump 20% next year seems somewhat unrealistic.

Given that backdrop, the risk here is that earnings growth will continue to decelerate in the coming quarters and that investors, in turn, will begin to question elevated valuations.

Tax Cuts/Policy

Many are expecting the “tax cut” bill (I put tax cuts in quotes because there are quite a few Americans who will see a tax increase under the proposed plan) to be passed by the end of this year, and the administration has talked about a resulting jump in real GDP to as much as 5%.

Is this likely to occur? No. The empirical evidence on tax policy alone spurring economic growth is far from conclusive. Much of the research on tax cuts that are not funded by non-productive spending cuts (as is the case here, will increase the deficit) show them to have an uncertain impact on growth (see here for one study that argues the impact is either “small or negative”).

That’s not to say that well-designed tax policy cannot increase growth at the margin, but it has to be well-designed which is far from clear in this case. Even if one believes that the “tax cuts” will increase real GDP by 0.5% next year, that’s still under 3% growth (real GDP currently running at 2.3% over the past year).

Real GDP of United States from 1948 to 2015

The key here is expectations. Expectations are high for this policy to have a large impact on growth. Anything that falls short of that will be a disappointment.

Global Central Bank Policy

Every developed country central bank in the world is maintaining negative real interest rates (easy monetary policies) 8 years into the global expansion.

Image of Global Central Bank Policy Rates

The risk here is obvious: a more hawkish transition to come. The Fed has already moved 4 times and is likely to move for a 5th time in December. They are projecting 3 more hikes in 2018 and the market is already pricing in hikes in March and September. This year, Canada, the UK, and the Czech Republic also hiked rates for the first time in years. Given the lack of deflation, the ECB and other European Central Banks could very well be the next to start normalization. Such a change may be good or bad but it is a change nonetheless, introducing more uncertainty in the minds of investors.

The Market’s Uncertainty Principle

In quantum mechanics, Werner Heisenberg proved that one cannot measure with precision both the position and momentum of a particle. Similarly, in markets, one cannot measure with any precision the position of the S&P 500 in the future and its momentum in getting there. Uncertainty is ever-present.

The economy, earnings, policy, and central banks all seem to be in a perfect place today, providing an air of certainty in markets that we have rarely seen before. But this certainty is only our perception, for if it was a reality we could predict the S&P’s future return and volatility with precision. But alas, we cannot come close to doing so.

The question here is as follows: are conditions over the next year likely to be as definitively awesome as they are today? As I have argued, that would be a difficult feat, and investors are likely to increasingly perceive conditions as uncertain going forward.

That doesn’t mean stocks can’t be higher a year from today, just that the path getting to wherever we’re going is likely to be much more difficult. That wouldn’t be the worst thing for investors, for it is perceived uncertainty that creates opportunity in markets (we saw this most recently in February 2016). When everything seems 100% certain, the risk/reward is never compelling.

So I’ll ask the question again…

As an investor, what do you prefer: certainty or uncertainty?


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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. Charlie holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and also holds the Certified Public Accountant (CPA) certificate.

In 2017, Charlie was named the StockTwits Person of the Year. He is a frequent contributor to Yahoo Finance and has been interviewed on CNBC, Bloomberg, and Fox Business.

You can follow Charlie on twitter here.


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