Crash Ahead!!!

Anybody who has spent more than a few minutes on the web has seen some amazing doomsday predictions. Among my favorites are those relating to the great Yellowstone Caldera volcano, which is often described as about ready to blow and destined to create terror and mayhem even though Yellowstone is pretty calm as giant caldera systems go. For example, check out the following headline from the Toronto Sun on March 9, 2014, which provides a good representative sample of the genre.Headline

The prose within the body of the article is more than a bit hyperbolic too.

Scientists have discovered Yellowstone National Park supervolcano is two-and-a-half times larger than previously thought, and it could erupt with 2,000 times the force of Mount St. Helens — a blast that would devastate North America and dump more than 10 cm of ash on Western Canada alone.

The national park and surrounding communities would be annihilated, while plants and entire farms hundreds of kilometres away would be wiped out. Escape would be futile — ash damages commercial aircraft engines, making flight hazardous.

Sulfur entering the upper atmosphere would turn to sulfur dioxide, circle the globe and drop temperatures. Worldwide famine would likely ensue.

Finally, toward the end of the article a bit of qualification is offered. “The chance per year of Yellowstone blowing up — they’re low…. But it’s potentially going to happen sooner or later.” The headline is the takeaway (and terrific click bait too).

In the investment world, threats of imminent market collapse are also commonplace. Notice these recent tweets, for example.

Most, such as this one, are carefully couched: “If you were to ask me for my favorite investment idea today, it is to get ready for a severe correction in the market; as such, at the very least, I like to have cautioned investors.” Others, however, are not – such as a real doozy from Paul B. Farrell last week. After having predicted “a 100% risk of a 50% crash in 2016 if Hillary Clinton wins the presidency,” Farrell added his prediction that there is a “100% risk of 50% crash in 2015 if McConnell’s GOP wins [the] Senate.”

Volcanologist Erik Klemetti of Denison University wrote an outstanding piece earlier this year outlining how to look at volcano doomsday predictions. He proposes four simple steps, each of which is applicable to threatened major volcanic eruptions, major market crash predictions and to pretty much any sort of analytical construct.

1. Consider your source. Unless the source is unimpeachable, ignore it.

Experts (and especially phony experts) are prone to the same weaknesses all of us are, of course. Philip Tetlock’s excellent Expert Political Judgment examines why experts are so often wrong in sometimes excruciating detail. Even worse, when wrong, experts are rarely held accountable and they rarely admit it. They insist that they were just off on timing (“I was right but early!”), or blindsided by an impossible-to-predict event, or almost right, or wrong for the right reasons. Tetlock even goes so far as to show that the better known and more frequently quoted experts are, the less reliable their guesses about the future are likely to be (think Jim Cramer), largely due to overconfidence, another of our consistent problems.

Source: xkcd

Source: xkcd

Since 1990, the Federal Reserve Bank of Philadelphia has conducted a quarterly Survey of Professional Forecasters, continuing research conducted from 1968-1989 by the American Statistical Association and the National Bureau of Economic Research. The survey asks various economic experts their views of the probabilities of recession for each of the following four quarters and comes up with an “Anxious Index” reflecting those asserted probabilities.

CXO study of that data determined that the forecasted probability of recession for a quarter explained absolutely none of the stock market’s returns for that quarter. In fact, the data suggests that the forecasts were a mildly (if not materially) contrarian indicator of future U.S. stock market behavior. The survey reads like a primer on recency bias in that bear markets lead to bearish market forecasts and vice versa while the forecasts have no predictive power whatsoever.

While I would love to find at least a few, there is little reason to think that anybody can predict major market movements with any degree of consistency (if readers have candidates to offer I’d love to see them). There is no reason to think that some guy on the internet can. Before you make serious portfolio changes based upon some urgent warning, be sure you are well aware of the risks and opportunity costs of doing so…and make sure you know the full and complete track record of the forecaster you’re relying on. Very few “expert” forecasters will talk about their misses and they all have lots of misses.

2. Consider the data. Demand lots of data from multiple sources and with careful confirmation.

1987 CrashMarket crashes happen. When the next one comes along — and it surely will, perhaps today, perhaps years from now — some number of people will seem to have presciently predicted it. Many more will try to take credit for having done so. Still, since such major catastrophic events don’t happen all that often and since there doesn’t seem to be any good reason to think that any particular person will have it right, acting on such predictions is dangerous business indeed.

As the legendary investor Peter Lynch cautioned, “Far more money has been lost by investors … trying to anticipate corrections than has been lost in corrections themselves.” That’s largely because big crashes (as opposed to corrections — which are common) don’t happen all that often. The worst one-day market loss occurred on Black Monday, October 19, 1987, when the Dow lost over 22 percent of its value. The biggest one-day loss in 2008 was 7.87 percent; in 2001 it was 7.13 percent. Over longer time periods there have been four secular bear market periods (see below, from Doug Short) when peak-to-valley losses were much greater. Secular Bear Markets dshortThe standard crash warning article does not specify whether a one-day or longer-term trend is predicted. Specificity is, of course, a great enemy of media pundits. One who keeps predicting doom without specificity will eventually be right, no matter how much opportunity cost has been paid in the meantime.

3. Consider the scale of things. Even if there is really good evidence of a current problem, most such problems are relatively minor.

As noted above, corrections are commonplace (see below, from Business Insider).10% correctionsSo if you own stocks and are terrified by the prospect of a correction — standard market volatility — you need to re-think your entire investment philosophy and dramatically reduce your return expectations (despite corrections, S&P 500 annualized returns from 1900-7/14: 9.70 percent; 1946-7/14: 10.83 percent; 1990-7/14: 9.71 percent). As John Bogle expressed it, “If you have trouble imagining a 20 percent loss in the stock market, you shouldn’t be in stocks.”

4. Consider the motivation. Does the forecaster have personal motivation for making the prediction?

Take a look at the list of people above touting an imminent crash. Most are selling something, have a political motivation for wanting to see a crash, or both. All are looking to make a name for themselves by getting a big call right. There is a wide body of research on what has come to be known as “motivated reasoning” and – more recognizably for those of us in the investment world – its “flip-side,” confirmation bias. While confirmation bias is our tendency to notice and accept that which fits within our preconceived notions and beliefs, motivated reasoning is our complementary tendency to scrutinize ideas more critically when we disagree with them than when we agree. We are also much more likely to recall supporting rather than opposing evidence. It’s why we concoct silly conspiracy theories, for example. In general, we see what we want to see and act accordingly. And if it’s in our interest to see things a certain way, we almost surely will. Upton Sinclair offered perhaps its most popular expression: “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”

So the next time you see some pundit warning of yet another imminent crash, use Klemetti’s analytical framework to test how likely you think it might be that the pundit is correct and act accordingly. Klemetti’s conclusion is an important one (emphasis in original). “Once you’ve moved through these 4 steps, you’ll find that 99.9 percent of all Yellowstone eruptions rumors are untrue, and you can go back to your normal life. Spread the word to your friends, co-workers and family: Don’t let the purveyors of misinformation send you down the path to panic. Instead, stand up to them and use reason and science to turn them away!”

Market crashes occur more frequently than major seismic events at Yellowstone, but they still aren’t nearly as common as they are commonly predicted. So the next time you see an article about Yellowstone predicting impending doom remember that calderas are busy places and the media loves its disasters. There is probably no reason to get too worked up. And the next time you see an article predicting a major market crash remember that markets are wildly busy places and the media loves its disasters there too.

17 thoughts on “Crash Ahead!!!

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  10. Great article – I encourage my clients to stopping listening to the “noise.” The media’s first responsibility is to create a story and sell advertising.
    Unfortunately a prognosticator only has to be right once (even if they are wrong 100 times before) to become the next “genius.”

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