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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 3rd 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
Lack of rudimentary knowledge of assets and how to value them – need
teaching sessions
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