A breakdown in trust

Trust is of crucial importance to society. Not to overstate the point, but if trust begins to crumble then society also starts to breakdown.

According to the Chinese philosopher Confucius, three things were necessary for governance: weapons, food, and trust. If a ruler is unable to obtain all three things, he should first give up weapons, then food, and finally trust. Without trust there can be no government at all.

Lack of trust is a tax on our economic, social, political and personal relationships. It slows us down and adds costs. “Trust, but verify”, said US President Reagan in response to negotiations with the Soviets. We have to trust, but spending too much time and energy verifying adds a heavy toll.

As the financial crisis began to intensify just over a decade ago it was trust in our financial institutions that dropped like a stone. Long queues formed as deposit holders eagerly waited to withdraw as much as they could from the bank lest anything bad should happen…

Image result for northern rock queues

Fast forward to the present day and concern over the spread of COVID-19 has resulted in a breakdown in trust in the physical economy: whether essential goods will be there in the shops when we need them and even in each other – aka ‘social distancing’.

As supply chains bifurcate this breakdown is likely to get worse. First Asia, now Europe and the US, next it will probably be south America. Countries are gradually closing their borders (arguably the horse has already bolted) in a bid to stem the flow of the virus.

Across Europe the impact on agriculture and food markets is becoming more tangible as more reports of grain truck movements stalling because of border closures and truckers unwilling/unable to deliver grains across the continent come to light. Concerns about supplies are becoming more fraught.

The symbol for this current breakdown in trust in supply chains is the humble toilet roll. An essential, non-perishable good with little downside to hoarding, supermarket shelves have been stripped bare of the quilted and not so square quilted tabs of tissue.

In the financial crisis a healthy cash balance under the mattress was a personal symbol of protection against the breakdown of the financial system. A measure of wealth has changed.

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The breakdown in trust may have another act in store. Precious metal dealers in Europe are reporting strong demand for physical gold and silver. And not just physical metal stored in a financial institution, actual physical coins and bars that you store in a private safe.

Precious metal dealers in Europe are reporting that premiums for physical metal over spot gold and silver have jumped to around 10% from parity normally. Meanwhile, stocks of physical metal – just like shelves previously laden with toilet rolls – are empty.

As central banks inject trillions of $’s into the financial system’s intravenous over coming days, demand for protection against the debasement and breakdown in trust of fiat currency is likely to surge.

The narrative machine

“As there are so many people who cannot wait to follow the prevailing trend of opinion, I am not surprised that a small group becomes an army.” — Josef de la Vega

Everything you see and hear is part of a narrative. Whether political, celebrity, financial, science, religious or sport. Every story we see is part of a narrative that makes sense on some level, be it personal, societal or cultural.

The prevailing narrative of our time is known as the zeitgeist. It includes the general intellectual, moral and cultural climate of a particular era and embodies all of our ideas and beliefs. The word zeitgeist comes from the German words Zeit, meaning “time”, and Geist, meaning “spirit”. The media (newspapers, TV and social media platforms) is both a mirror on the zeitgeist, and also a chief protagonist in its development.

We tend to think of the story coming last, after the action or event – the tidy narrative that ties everything together into a cohesive explanation. The reality is that it is often the story that comes first. To achieve something we have to believe that it is possible. We have to construct a narrative in our minds of what the future could hold.

The stories we tell have the power to motivate a nation, to finance projects that had previously been seen as impossible and to help ourselves meet our goals. Stories drive action. Action drives results. Results, in turn further drive the story. As Daniel Kahneman, author of Thinking, Fast And Slow said, “No one ever made a decision because of a number. They need a story.”

But why do some narratives gain traction and spread, while others wither and die? The answer is important since the narratives at work in the world are driving your actions right now, whether you know it or not. According to Malcolm Gladwell, author of The Tipping Point you need three things for a narrative to spread; the right people, a sticky story and the right context.

The right people

Who are the right people to spread a narrative? There are three distinct groups; connectors, mavens and salespersons.

Connectors are not just people that know a lot of people; they have a special gift for bringing the world together. Think of a connector as someone who has lots and lots of acquaintances, in Gladwell’s words, “We rely on them to give us access to opportunities and worlds to which we don’t belong”. The closer a story, idea or compelling piece of information comes to a connector the more opportunity it has to spread.

The strength and speed with which a piece of information spreads depends upon the ‘majority illusion’. When people believe that a majority of their network think a certain way – whether that perception is correct or not – they are more likely to act on it. Connectors play a central role.

While connectors are people specialists, mavens are information specialists. Mavens are unique in that they go out of their way to help, sharing their knowledge. Mavens have the knowledge and the social skills to start word of mouth epidemics. They spot trends, patterns and insights that other people have neither the inclination nor the patience to find, let alone share with others. Think of the maven as the investigative reporter who doggedly pursues dead end after dead end before finally coming up with the nugget of insight that she can share with the world.

The final group of people that are required to turn a narrative into an epidemic is the salesperson. While connectors bring disparate groups of people together, mavens share information, salespersons persuade. Salespersons have the charisma to persuade you that a narrative is worth paying attention. Rather than being the result of what they say, it’s normally what they don’t say that is so persuasive. These non-verbal clues are often what motivate people to act a certain way.

A sticky story

Narratives vary in form, across time and often even between telling’s. For a narrative to spread, for it to go viral requires a contagious element. This isn’t always evident in advance, but by looking at what narratives worked in the past we can begin to see the tell-tale signs.

Chip Heath, a Stanford University professor had spent years researching why some ideas won out in the social marketplace, cataloguing the unique characteristics of sticky ideas such as proverbs and conspiracy theories. His brother, Dan started an education start-up firm that sought to re-imagine the textbook. He discovered that the best teachers all had a very similar method to make ideas stick with their students. In their book, Made To Stick: Why Some Ideas Survive and Others Die the brothers outline the 6 principles that makes a story stick:

1. Simple: There is a reason proverbs stick; they are simple and profound.

2. Unexpected: Ideas that stick violate our expectations. They generate interest and curiosity.

3. Concreteness: Sticky ideas are often encoded in concrete language. Think of the proverb, “A bird in hand is worth two in the bush.”

4. Credibility: Sticky ideas force people to question themselves or others around them.

5. Emotion: You and I only care about an idea once it makes us feel a certain way.

6. Stories: Stories, whether true or false engage us. They take us on a journey, while the best captivate us.

The right context

The third and final factor behind the transmission of narratives is the power of the right context. According to Gladwell narrative epidemics are “sensitive to the conditions and circumstances of the times and places in which they occur”. When someone wakes us from our sleep to tell us something we assume it must be important. If we hear something that resonates with us on a personal level, particularly when it’s connected with the emotion of fear then it weighs more heavily in our minds.

The media is also complicit. An on-going narrative is highly valued by the media because a story that fits an existing storyline is strengthened by every subsequent story. If the broader narrative is considered important or compelling, no story is too small to run.

More reporting puts more examples and more emotions into more minds. Public concern rises, and reporters respond with more reporting. The feedback loop is established and the narrative continues to grow stronger and stronger.

People and institutions with an interest in a particular issue staying in the public spotlight (politicians, lobbying groups, campaigners and businesses selling a solution) ride this feedback loop but they also hope to perpetuate it. The point to remember is that just like a spinning top only needs a slight nudge to keep it revolving, outside influencer’s just need to nudge here and there in order for the narrative feedback loop to keep on spinning.

It is only when something dramatic happens that the feedback loop is broken. The spinning top is knocked over. It’s only then that we often wonder why we paid so much attention to something of so little consequence for so long.

Conversely, if a story isn’t part of a larger narrative, or if it contradicts the existing media narrative it is far less likely to see the light of day. Big events happen all the time. Compelling human interest stories are everywhere. However, if the story doesn’t fit then it may not get the air time it might otherwise have received had the existing media context been more in line. The impact of that event or story fails to grow.

The most contagious of all narratives is gossip. Psychologists have discovered that three things happen when rumours develop and spread. First, the story is levelled with details essential for understanding the true meaning of the event left out. Second, the remaining details are sharpened with extra information – whether true or not. Finally, the story is assimilated and so it makes sense to those spreading the gossip. Who does the levelling, sharpening and assimilating? Why, the right people of course! The connectors, mavens and salespeople of this world.

The narrative of the rumour, or indeed any story that takes hold is constructed from three basic building blocks: sentiment (whether a story is positive or negative), attention (the volume of the narrative) and cohesion (the consistency and strength of the narratives foundations). The right people have a defining role in how the structure of a story changes over time. Look out for these three building blocks and you will begin to see their work.

While much of the language about narratives is cloaked in the language of disease (contagion, infected), the important point to take away is that narratives are an entirely human construction. Narratives are constructed, and spread. Narratives are embraced, and passed on. With the right people, the right story and the right context narratives spread – because ALL of us want them to.

 “The Emperor has no clothes”

If a compelling narrative can drive change, then a loss of belief in that narrative can result in change to stall, or even to reverse. Remember, narratives require certain types of people, a sticky story and the right underlying conditions (the context) in order to spread. A change in those underlying conditions may result in doubt to set in, and then once it reaches a certain threshold, the process can quickly tip into reverse.

Ever wondered why some stories in the media (especially the scandalous variety) suddenly appear, seemingly out of nowhere only to find out later that people, often many people already knew about it? That’s the power of the narrative machine.

Think back to a time when you have heard a scandalous report in the media about a celebrity. You were understandably shocked (SHOCKED!!!) that this person could have done such a thing. You went to this person’s public appearances, you bought that person’s products, hell you were only wearing a T-shirt with their name on last week. What happened? How could this scandal have stayed under wraps for so long?

To understand this we have to consider the three types of knowledge – private, public and common. Private knowledge is the information locked up inside our heads, while public knowledge is information that everyone knows. However, making sure that everyone knows the truth (public knowledge) isn’t enough for a narrative to spread. People only change their behaviour when a narrative becomes common knowledge. Common knowledge is when knowledge (it can be either private or public) reaches a state when everyone knows that everyone knows that everyone knows it to be true.

The classic example of the common knowledge game is the fable of The Emperor’s New Clothes. Everyone in the crowd possesses the same private information — the Emperor is walking around butt naked. But behaviour doesn’t change just because private information is ubiquitous. Nor would we expect behaviour to change because a couple of people whisper their doubts to each other, creating pockets of public knowledge that the Emperor is naked.

The only thing that changes behaviour is when the little girl announces the Emperor’s nudity so loudly that the entire crowd knows that everyone else in the crowd heard the news. That’s when behaviour changes. It’s only when that transition to common knowledge happens that behaviour changes. And it can change very fast. Scandals come to light in the media through the narrative of a victim, or someone brave enough to shout loudly enough. In game theory this person is known as the missionary.

As human beings we have great trouble in understanding how change actually happens. We like to believe we live in a world where small changes have a direct linear impact on outcomes. That is not how the narrative machine works. Narratives have their own structure. Narratives don’t correspond to linear change; they involve and require distinct jumps and changes in behaviour. Understand that structure and you will begin to see them everywhere.

The worst except for the others

Amidst the carnage that is the oil market post COVID-19 outbreak / OPEC+ breakdown forecasters from the major banks have been quick to outline their thesis for why oil prices will remain low or drop even further.

According to Goldman Sachs the demand shock from the spread of the coronavirus was equivalent to that seen in 1Q 2009 amid the financial crisis, while the production surge was likely to be much like that seen in the 2Q 2015 setting the stage for “a likely 1Q16 price outcome.”

“As a result, we are cutting our 2Q and 3Q20 Brent price forecasts to $30/bbl with possible dips in prices to operational stress levels and well-head cash costs near $20/bbl,” they wrote.

History suggests that investor attention will soon seek guidance as to whether now is the right time to dip a toe back in the energy market. The chart below shows global search activity for ‘oil prices from 2004. The financial crisis and the surge in shale output / OPEC restraint post 2014 captured peoples attention. Despite the surge in volatility oil prices have failed to ignite the Google algorithms. Not yet anyway.

Google Trend – ‘oil prices’

But before you base your investment decisions on the word of Goldman Sachs its worth recalling why they might not be worth paying too much attention to. For a forecast to be useful for a commodity investor it has to have three qualities: it has to be correct, it has to anticipate change ahead of the market and it has to have led to a better overall result than taking the consensus.

What follows is an extract from my book, “Crude Forecasts: Predictions, Pundits & Profits In The Commodity Casino” on the poor oil price forecasting record of investment banks and other financial institutions.

Hint: Not great, and Goldman Sachs are worse than most. Skip to last few sentences to see exactly how poor.

The Wall Street Journal (WSJ) polls institutions every month on a range of economic variables including inflation, unemployment and West Texas Intermediate (WTI) crude oil prices. Each month, the survey asks for predictions for the forthcoming June and December. For the sake of consistency, I have reviewed the accuracy of forecasts made both six and 12 months prior to June and December each year. I reviewed surveys from mid-2007 to the end of 2016 and so this covered booms and busts, financial crises and quantitative easing, the Arab Spring and the shale revolution.

By means of a disclaimer, this is not an exhaustive study. By definition, it only covered a ten year period, and there is no guarantee that forecasters that were correct during this boom and bust period will be any more or less successful in future periods. It also says nothing about how well those same institutions did trying to predict other commodity prices including metal and agricultural prices. Finally, it only covers those forecasters that the WSJ surveyed – there may have been others who were more or less accurate in their predictions.

First, were the forecasts right? The answer was clearly no. The average consensus forecast (ie, the average of the commodity price predictions) for WTI crude oil was off by 27% when forecasting six months out. Oil price forecasts looking twelve months out were only slightly worse, off by an average of 30%. Another way of looking at it is that only in three of the nineteen periods reviewed was the consensus six month forecast within 5% of the actual result.

As noted earlier, producers, manufacturers, investors and traders are making billions of worth of investment based on the outlook for commodity prices. If these forecasts are awry on as short term a time period as twelve months then how can they have confidence making decisions over much longer time periods?

Second, did any of the forecasts spot the major changes in the direction of the oil price over the past decade? In June 2008, WTI crude was trading at approximately $135 per barrel. The consensus prediction for December 2008 was just under $112 per barrel and $101 per barrel twelve months ahead. The reality was somewhat different. The financial crisis hit and with it the oil price was hit too. WTI crude prices fell to $41 per barrel in late December 2008, only rebounding to $70 per barrel in mid-2009. Almost all forecasters polled in mid-2008 saw prices falling over the next twelve months, but no one saw the scale of the collapse. The closest six month forecast, although over 50% higher than the outcome, came from Parsec Financial Management!

It was a similar story in trying to call the rebound in prices. Remember that oil and other commodities rebounded in 2009 as quantitative easing helped support prices. Back in December 2008, however, the consensus prediction for June 2009 was for prices to stay low, only nudging up from the current levels of the time. This time the consensus was over 30% too low. Only three forecasts called the market within 5%: Societe Generale, Barclays and the Economic and Revenue Forecast Council.

Over the next few years, oil prices traded in a gradually narrowing range between $70 and $110 per barrel. Sure enough, the consensus and individual forecasts, increasingly anchored against recent prices, turned out to be broadly correct – well at least within a range of 5–15%. Like many forecasters, these economists were driving with their eyes fixed on the rear view mirror, enabling them to tell us where things were but not where they were going. This bears out the old adage that “it’s difficult to make accurate predictions, especially with regard to the future.” The corollary is also true: predicting the past is a snap.

If we fast forward to June 2014, oil prices were trading at approximately $105 per barrel, having peaked at just over $112 per barrel ten months earlier. The consensus forecast was for oil prices to fall from those levels to below $99 per barrel in December 2014. In reality, the consensus proved too optimistic by 85%. All of the forecasters were over 65% too optimistic, apart from one – Parsec Financial Management had predicted oil prices to be in the late $60s per barrel range in December 2014, only 24% too high.

Does that mean that Parsec Financial Management have superior insight? Well, not quite. A look back through earlier forecasts reveals that they were consistently bearish all the way back to early 2010, calling for oil prices to stay around $50–70 per barrel, even though oil prices kept on rising. This is what’s known as the “stopped watch” method of prediction. If you keep on saying something extreme will happen and it eventually does then you are feted as a guru when, in reality, you were lucky (eventually) with the timing.

Predictions are most useful when they anticipate change. If you predict that something will stay the same and it doesn’t change, that prediction is unlikely to earn you much money or wow clients with your predictive abilities. However, predicting change can be very profitable for investors, while timing hedging strategies can be a welcome boost to both producers and manufacturers.

Third, was there a forecaster that you could have followed that would have led to a better overall result than taking the consensus? Of those 26 institutions that contributed prices for at least 14 of the 19 forecast periods and during the key turning points in the market identified above, three forecasters achieved a better than average result than the consensus when looking over a period of six months. These were: JP Morgan (26% forecast error, 4 correct calls); Comerica Bank (25%, 2) and The Conference Board (25%, 3). The most accurate institution achieved a two-percentage point improvement on the consensus, but still had an average six-month forecasting error of well over 20%. The research sample also includes Goldman Sachs, often famed for its supposed commodity prediction ability. How did they do? They were an average of 36% off with one correct call.

Related article: Why do economists have an abysmally poor prediction record?

Related article: The futures curve is not a price forecast