About Predictions and Markets

Two things happen when enough people react to a prediction:

1) the prediction comes true faster than it otherwise would under normal circumstances.

2) the prediction doesn’t happen at all.

Let’s take a look at two cases that cover each of the aforementioned scenarios:

Scenario 1: If enough people believe in the bright future of a company, they start bidding up its share price even if it is still losing money every quarter. The higher stock price will allow that company to hire the brightest employees and management; to buy promising smaller competitors, which will lead to a better market position. The overall improvement in profitability will be accepted as a positive feedback by the market and even more people will buy this company shares. Everything will happen a lot faster than it otherwise would. In this case, the initial expectations of a brighter future could turn into a self-fulfilling prophecy. When good market faith meets smart management, a story stock could appreciate very quickly.

Scenario 2: If enough market participants believe that there’s a major correction coming around the corner, many would simply buy put options to protect long-term positions and ride out the storm with a minimum drawdown. One could argue that if enough people believe there’s a deep correction coming, everyone will sell and actually cause this correction to happen faster and be even bigger. The truth is that funds that actually move markets don’t go to 100% cash. They just reallocate capital between less liquid, but more lucrative asset classes and hedge. Since everyone will start buying protection, volatility will spike. Equity prices might not drop more than a few percent¬†because most funds would be already protected and they won’t sell their positions. Put options will expire worthless. Correction predictors will be made fun of. Everything will go back to normal. By definition, deep market correction always comes by surprise for most. If enough people expect a correction and act on their perceptions, it will either not happen at all or it will be much shallower than most expect. I’d be a lot more concerned when the market is down 5% and everyone is blindly buying the dip than when the market is down 5% and implied volatility is through the roof because everyone is afraid and buying protection.