Predicting Rain or Building an Ark - What's More Important?
Economists - whether the armchair quarterback kind or the well-educated, well-funded think-tank kind - like to read the tea leaves and guess what will happen next, based on where we are today. While I am one of the former (an armchair quarterback), I have been around long enough to know that any forecast or prognostication based on history is like driving fast while only looking at the rear-view mirror. You can't really see what's coming from a model alone, and if we all have learned anything in our lives, it is that change is inevitable and that there are always surprises.
Armchair quarterback. Never would have called the Philly Special on 4th down.
I remember reading in the fall of 2008 about hedge fund modelers saying September 15th was a “1 in 10,000 year event” in their models. And then another 1 in 10,000 year event happened on September 18th. And then another and another. I guess it wasn’t really a “1 in 10,000 year event” after all. A similar event happened in October 1987 (21 years) and also in October 1929 (80 years). As if their models actually could predict the future over 10,000 years! That’s not truth, that’s hubris. The truth is that models are least accurate just before a crisis. Because at that point, the last crisis is farthest away from the present moment, so as you get farther away from the crisis event, its impact on your data affects your forecast less and less. Consider that as a modeler, you’re driving forward by looking at the rear view mirror. You look backwards (historical data) to predict the future. Eventually the road bends.
Please pardon this rant...
What is the point of this rant? Well, there are qualitative elements to consider as well as quantitative in any exercise of prognostication. Imagine you are the captain of a massive ocean liner.
You can’t change course without many people exerting significant energy and time. The least resistant course is the steady course. Yet you sense headwinds ahead. You get an unconfirmed report about icebergs potentially in your present northerly course, and you know it would be best to avoid it. You’re the captain – what do you do? Do you plot a different course, making a bold move south to course-correct to what you think is a safer but more costly-in-the-near-term path? Or do you stay on the northerly path? Either call is a bet on the future. This is where we are. We have sunny skies, calm seas and a (theoretically) unsinkable boat. What can go wrong?
Titanic II. Currently under construction by some billionaire.
Economies do not always go up. We are in the midst of a 9-year bull market, one of the longer ones historically. I believe that we are nearing the end of the cycle, which has been so long due to the extension of central bank QE stimulus in the wake of 2008. We are in the euphoria phase – that last phase where even cashiers are buying stocks on E-Trade. The hysteria of Bitcoin is a tell-tale sign that the horses are out of the barn and running wild.
And –the Fed is raising the short term rate to prevent the economy from over-heating. Their number 1 mandate is to prevent inflation, and they use interest rates to manage it. Google Paul Volcker for details. Credit has been so cheap for so long – due to the lingering QE stimulus – that the Fed, the ECB and other central banks have to start pulling back on their unprecedented intervention into national economies. Otherwise they risk runaway inflation. So the Fed will slowly start selling Treasury bonds that they have been holding into the open market.
Paul Volcker. Raised the Fed Funds rate to 20% in 1981 to stop inflation.
As the Fed implements this strategy of selling the trillions of dollars in bonds they bought, the bond market will inevitably cool off and bond rates will rise to a new equilibrium rate, affecting mortgage rates. As part of QE, the Fed has been buying bonds for years, holding down the long-end of the yield curve with their fat finger. The 10-year US Treasury bond – a harbinger for 30-year mortgage rates – has been well below 3% for nearly a decade. Now it is testing 3% and mortgage rates are rising to the point (4%-4.5%) where people can’t afford homes at current prices.
There is a glut of new-home supply, but a shortage of existing home supply. Builders are building houses too big and expensive for folks to afford with the higher rates. Folks want to buy cheaper homes with smaller, more efficient footprints. I have long believed that changes in housing prices are an excellent predictor of changes in the bucket 1 roll rate.
Initial jobless claims hit their lowest point recently – 210,000 – since 1969. In other words, the Jackson 5 appeared for the first time on the Ed Sullivan Show the last time jobless claims were this low. That seems to be a tell-tale sign of an overheating economy. Unemployment is known in economics as a lagging indicator… so when it’s good, things are usually about to turn south.
So what is my grand conclusion? I don’t have one. I’m just thinking about all this and trying to figure out what it means. I will leave you with an amazing Warren Buffett quote to ponder. The man has beaten the S&P 500 Index for 40 years and is the 4th wealthiest man on the planet based on his ability to accurately predict the future value of companies.
“Predicting rain doesn’t count. Building arks does.”
His economy of words is striking. He said in 7 words what I am trying to say with hundreds. But before anyone accuses me of being a perma-bear, I’ll leave you with another Buffett quote.
“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
America is resilient, and so our financial institutions will be resilient as well. Not just for ourselves; but for our customers. We have no other choice. Let us all consider what it would take to build an ark to protect our portfolio from the storms to come.