How Not to Predict Crisis

According to the left, financial crisis is always immanent and everything is a bubble. Liberals like Peter Schiff and Nicolas Nassim Taleb have argued that the financial system is more prone to collapse than before 2008, even though they have been repeating this line for the past five years to no avail. Instead of being honest to their followers about their inability to predict, they keep shifting the timeline of crisis to the right, like you learn to manipulate functions in algebra class. Eventually, if just by dumb luck, one of them will call the top the bull market market, the next banking crisis, the top of the housing market, etc he will be showered with adulation for ‘predicting what no one else saw coming’. What is ignored, however, are the countless wrong predictions and that doom and gloom predictions are common.

In late 2008, liberal economist Shiller intimated that stocks could fall in half again, bringing the PE ratio of the S&P 500 to just six; instead, it bottomed at 13. Anyone that heeded his warning would have sold at the worse possible time.

In terms of the stock market, the price/earnings ratio is no longer high. I use a P/E ratio in which the price is divided by ten-year average earnings. It’s a really conservative way of looking at it. That P/E ratio got up to 44 in the year 2000, which was a record high. Recently it was down to less than 13, which is below the average of around 15. But after the stock market crash of 1929, the price/earnings ratio got down to about six, which is less than half of where it is now. So that’s the worry. Some people who are so inclined might go more into the market here because there’s a real chance it will go up a lot. But that’s very risky. It could easily fall by half again.

Notice how he used vague language like ‘could’.

A second strategy is to give a locus of predictions – some of which may be diametric – and then taking credit should any one of them occur. Since the locus covers most outcomes it’s hard to be wrong. Henry Blodget used this technique when he predicted a week ago that stocks could crash and then hedging his bet by saying that they could also surge higher and that he isn’t selling. Notice what he has done: he phrased his prediction so that he cannot possibly be wrong unless, perhaps, the market is flat. He made this identical prediction in September 2013, but now that the market has risen 15% he can fall back on his hedge and give himself a pat on the back for not selling.

Minsky Moment is the latest buzzword

He thought that the system itself could generate shocks through its own internal dynamics. He believed that during periods of economic stability, banks, firms and other economic agents become complacent.They assume that the good times will keep on going and begin to take ever greater risks in pursuit of profit. So the seeds of the next crisis are sown in the good time.

There have only been two veritable Minsky moments in the U.S. in the past 100 years (1929 and 2008) and it offers no way of timing when the moment will actually occur. Terms like ‘risk’ and ‘frothy’ are only useful when a baseline for normal behavior exists and even if it does deviate from the baseline, you don’t know how far it will overshoot or if the baseline itself is invalid.

This renewed belief in the instability of the financial system an example of the current moment bias because of the recency and severity of the 2008 crisis creates the illusion that the U.S. financial system is on a new trend of instability when, in fact, there have only been two banking crisis in the U.S. in the past 100 years – 1929 and 2008. Such a dearth of data is hardly sufficient grounds reject the null hypothesis that banking crisis are inherently rare, yet this is what many pundits are doing. That could explain why so many experts like Schiff, Roubini, Richard Russell, Mauldin, etc incorrectly predicted the U.S. financial system would quickly relapse into a crisis, bear market or a double dip recession. Five years after the bottom and stocks still keep going up with no end in sight. 29 of 30 banks passed a recent stress test. The left wants economic crisis as punitive retribution against the rich. You can join in their choir of negativity, or you can to extricate yourself from the morass of liberalism and choose to believe that we are not doomed, that the world is becoming less violent and more prosperous, that stocks will keep going up and that the free market is the best path to prosperity.