Financial Predictions for 2007 – How Did I Do?

In January 2007 I thought it would be fun to make some financial predictions. Although this task was just for fun, and no true predictive powers are claimed, let’s see how I did.

• Volatility will increase from its current low level (about 10.5)
  • Result: the VIX rose from 10.5 to a high of 37.5 before falling at year-end to 22.5. Correct.
  • Comment: I am surprised at how high the VIX went during 2007. I view the long-term average to be between 15 and 20.
• Oil will spike sometime during the year with a $60/barrel floor
  • Result: the price of a barrel of oil reached nearly $100/barrel and consistently has been over $90 the second half of the year. Correct.
  • Comment: Long-term the price of oil will increase until an alternative energy source is developed. If the price stays at current levels I believe it is economical to develop additional oil sands in western North America. While oil could spike temporarily, this will provide a long-term cap on the price with global economic and security implications. A financial solution will have fewer unintended consequences than one subsidized by governments.
• Credit risk will increase – note especially junk bond spread widening and ARM/junk home mortgages going into default
  • Result: Correct.
  • Comment: The concern today is whether the sub-prime issues have played themselves out. I don’t think they have, and expect commercial mortgages and junk bonds to struggle in 2008. My worry is what consequences remain from this bubble in areas not obvious today.
• No recession
  • Result: Correct.
  • Comment: the economy should start to recover before the fall 2008 election as the Fed’s rate cuts kick in, although the first 9 months may be challenging.
• Home building sector will finish bottoming and level or slightly improve depending on interest rates (up would be worse)
  • Result: this one is still unclear. Just recently existing home sales improved, which was the first good news for this sector in quite a while. Too soon to tell, but definitely not correct so far.
  • Comment: the rate environment driven by the sub-prime issues lowered rates but made liquidity dry up.
• The dollar will continue to deflate, especially relative to the Yuan
  • Result: the dollar did not have a good year. Correct.
  • Comment: the United States is in a scenario where the results will only be obvious in hindsight. If countries who are heavily invested in dollars, such as China, Japan, and the oil exporters, choose to dump dollars then US Treasuries will spike and the US economy will find itself in a vicious cycle. So far they are converting their dollars into US assets, reminding me of the early 1980s. Congressional hearings are sure to follow.

Risk Concerns

• Pandemic influenza – business continuity, impact on small businesses, combination with malaria/AIDS in Africa
  • Comment: the world moved closer to a pandemic in 2007, with human clusters becoming more frequent. It is a race for the virus against the medical community. Even if the medical community is successful, the impact during the first wave and in 3^rd world countries will be material.
• Increased drug resistance (e.g., tuberculosis or pneumonia)
  • Comment: infectious diseases are starting to win the battle over antibiotics.
• Global warming – unexpected side effects like new viral/bacterial attacks, along with coastal flooding and increased hurricane activity
• Terrorism
• Principles-based capital will be abused by some and will not be caught initially by peer review
• Can an internal CRO be strong enough to stand up and be counted, or will fears for their job keep them “in line”
• Tort reform needed
• US gridlock/ presidential campaign
• Malthus – too many people, not enough food
• Economy – risk of stagflation and the lack of internal hedge for investors holding both equities and bonds
  • Comment: this risk increased quite a bit during 2007
• Counterparty risk – it is currently so concentrated that one misstep could have major repercussions
  • Comment: much of the economy is now concentrated in a few parties. This leads to more risk in the system and more correlation in the tails. Financial experts seem to either rely on models that aren’t accurate in the tail or focus on top line rather than bottom line growth.

Top Actuarial Issues

• Defined benefit plan valuation – needs to reflect marketplace economics
  • Much more needs to be done here. Actuaries from other disciplines should be welcomed, along with those from outside the profession. More focus should be on cash flows rather than regulatory issues.
• Demographics – designing the next retirement insurance product