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The Counterfactual

Eric Freedman
CAPTRUST Chief Investment Officer

Early in my business school tenure, the recently retired Dr. David Crawford began the first day of our Managerial Economics class by asserting that the world consisted of three groups of people, and these three phyla were mutually exclusive and collectively exhaustive. The first group included engineers, physical scientists, and general numerate and facile individuals Crawford affectionately dubbed “gearheads.” Crawford assigned accountants and controllers to a second order titled “bean counters,” prompting smiles among several of my classmates with corporate treasury roles. “The rest of you,” exclaimed Crawford, “are poets.” Raising his voice for effect, Dr. Crawford boomed: “And poets do not do well in my class!” Unsure of how to react, 130 classmates simultaneously self-assessed their newly anointed labels. While some nervous laughter followed, Crawford’s intense-yet-stoic face made it clear the man meant business.

My classmates and I now joke that even our Leadership and Public Communications courses were highly quantitative. Our alma mater emphasized the need for evidence-based, data-driven conclusions; half-baked hypotheses and unconfirmed solutions were anathema. We were trained to use data whenever possible to confirm or refute claims that are too often evaluated through loose associations. As my marketing professor Dr. Eric Bradlow frequently reminded us as we sifted through analyses, “The math does not lie.” 

Across disciplines, we spent considerable time pondering what psychologists call the “counterfactual” — loosely defined as what series of events would have transpired had a certain action occurred or not occurred. For example, me stating that my jeans would be looser each November if I didn’t help my children eat their Halloween candy is a counterfactual; perhaps my waist expanded due to some other reason (or, as the optimist in me hopes, maybe the jeans themselves shrank!). The philosopher and professor Nassim Nicholas Taleb calls these events “potential histories” and argues that when thinking about potential histories before an outcome occurs (in my case before the Snickers bar passed my lips),  one must take into account that the actual outcome is likely to be a lot different than one expects.1 Said another way, forecasting is subject to large deviations from perception.

The most significant counterfactual in today’s capital market environment surrounds global monetary and central bank policy, with investors thinking about potential histories that may evolve should the Federal Reserve or other central banks scale back their recent pro-growth policies. Put more simply, do we need the Fed and its global peers to keep printing money and buying assets in order for riskier asset classes to deliver returns? Applying data-driven thinking about what the world will look like after easy-money-policies is a challenge for professional investors; we simply haven’t been here before on a global scale.

Since 2007-08, central banks have implemented several policies designed to offset anemic consumer trends, reducing key interest rates and purchasing assets in the open market (via programs like quantitative easing) to help stimulate borrowing. Figure One shows five major central banks’ respective balance sheets, with each moving from the “lower left to the upper right” as banks have purchased sovereign bonds, mortgages, and other assets to try to keep rates down and spur economic output. Six years later, the world is in a very uneven place from a growth perspective, and differing regional responses highlight these variations. 

In some regions, central bank activity can be characterized as consistent with recent policymaker activity. A centrally planned economy enduring growing pains in the form of property price volatility and high disparities between rich and poor, China continues to offer the market mixed signals about its monetary policy intentions, thus retaining a somewhat neutral positioning relative to some of its peers. The European Central Bank (ECB) has also been in a holding pattern despite weak economic growth; Europe’s GDP dropped by 0.6% in the fourth quarter of 2012, with even the venerable Germany seeing its economy contract by the same amount, yet ECB President Mario Draghi has not budged on stimulus measures.

Two major economies that appear to be in transition are the U.S. and the U.K., although they are seemingly heading in opposite directions. The latest U.K. Monetary Policy Committee (MPC) meeting revealed that the MPC, which is currently engaged in a stimulus program where the Bank of England maintains a stock of £375 billion in asset purchases, was split on maintaining that asset purchase level with three of nine committee members (including outgoing leader Mervyn King) requesting even more asset purchases.2 In the U.S., where central bankers have committed to purchasing $85 billion per month in mortgage and Treasury bonds until the labor market improves, recent Fed-watch chatter has centered on when the Fed may start to scale back its purchases. While Fed Chairman Ben Bernanke has been adamant about a “full steam ahead” orientation, other Fed officials have been more tempered in their public appearances.

Japan recently switched to “full steam ahead” to the third power, committing to an aggressive monetary policy path after a decades-long economic malaise. Newly elected Prime Minister Shinzo Abe campaigned on a platform of bold new action, and his newly installed Bank of Japan Governor Haruhiko Kuroda said he would do “whatever is needed” to combat persistent deflation.3 The central bank surprised markets in early April, communicating a two-year plan to reverse deflation with asset purchases on a large scale (the total size was nearly twice what prognosticators thought) and scope (asset purchases will not be limited to the bond market). Markets anticipated Abe’s accommodative policies, helping push the Nikkei stock index up more than 40% from mid-November 2012 to early April as the yen plummeted.

While central bankers cite economic growth as the end stimulus goal, it is important to make the distinction between economic growth and asset price returns (e.g., equity market returns); several studies have analyzed long-run capital market and economic growth statistics and found very little relationship between GDP growth and stock market returns over time.4 The recent Japanese experience reflects these findings. Japanese economic fundamentals did not improve by more than 40% in the last four and a half months, and the Japanese equity market began its ascent long before Abe and Kuroda communicated their plan. Instead, market perceptions about future easy-money-policies took over, driving riskier asset classes higher before their efficacy is even proven. Similarly in the U.S., since 1994, “there has been a large and statistically significant excess return on equities on days of scheduled FOMC (Federal Open Market Committee) announcements,” according to a 2012 New York Fed staff report conducted by David Lucca and Emanuel Moench, providing empirical evidence that central bank policy moves markets.5 Seemingly, understanding the linkage between central bank policy and asset class returns is more important than what bearing central bank policy may have on broad economic growth. Or is it?

Since central bank policy and economic growth are linked in the eyes of policy makers, and central bank policy and riskier asset class returns are empirically linked, by implication we may be in a period where economic growth and riskier asset class returns demonstrate a relationship, although they could move in opposite directions. If economic growth returns in earnest, central banks like China and the U.S. may be reticent to push forward with or continue stimulative policies, which could hurt stock prices if investors view policy makers’ easy-money departure as premature. If growth is weaker than expected or desired, central banks may step up asset purchases and other easy-money policies, supporting riskier asset classes. In other words, seemingly good economic news may be interpreted as bad for equity prices if markets don’t perceive it to be good enough. This, of course, assumes reasonable expectations for corporate profits and riskier asset class valuation doesn’t get out of hand.

So, what is our investment strategy in a world with a few too many potential histories? What counterfactuals should we focus on to benefit client outcomes, and will markets be driven by perceptions about future actions or more focused on the present? In addition to an intense focus on valuation, we continue to center on central bank policy, leading economic indicators, and market psychology. We see the glass as half full for asset classes to ascend higher, and we do not share the consensus view that interest rates will be on a potentially quick upward trajectory, hurting bondholders as they rise. Given how uneven the world is — and potential histories subject to central banks treading where the data has not yet traveled — gearing for more growth, while being respectful of downside potential, particularly after such strength across many asset classes since late 2012, is our baseline mindset heading into the second quarter, a mindset we deem appropriate for gearheads, bean counters, and poets alike. 


1 Taleb, Nassim Nicholas. The Future Has Thicker Tails than the Past: Model Error as Branching Counterfactuals (May 23, 2011). NYU Poly Research Paper. Available at SSRN: or
4 See for example Inker, Ben. Reports of the Death of Equities Have Been Greatly Exaggerated (GMO White Paper, August 2012)



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