Predicting Booms and Busts

John Aziz (www.msn.com) penned an interesting article recently where he asked the question “are financial crisis really preventable?” And the answer, not surprisingly, is that they are not because “the world is just too unpredictable.”

In order to prevent something, you have to first be able to articulate a cause and effect. The real estate bubble that caused the 2006 financial crisis was years in the making. And while some – very few in retrospect – articulated concerns about an impending sell-off, the price escalation lasted much longer than anyone could have predicted.

History is filled with similar examples; the internet tsunami in the 1990s, Japan in the 1980s, tulip bulbs in the 1600s and virtually any boom and bust scenario throughout history. Fear leads to euphoria ending in calamity.

And looking back, was there a smoking gun that might have predicted or better, prevented a boom leading to a bust? Could Congress have enacted legislation that tightened controls on mortgage lending in 2005? Did the Japanese government raise any red flags about the asset bubble in the 1980s? Unfortunately, preventative measures are brought into play only after the fact. And that cause and effect leads to another boom bust cycle.

Think about it in todays’ terms. Regulators try to reign in risk with tighter controls on derivative transactions and credit availability, which creates a vicious circle of unintended consequences. Central banks provide excess liquidity in an attempt to encourage lending that cannot occur because of a tighter regulatory framework. Fact is money knows no borders and attempts to rein in leverage within the real estate sector create other bubbles, like the meteoric rise in equity values despite questionable economic fundamentals.

Despite all academic evidence in support of efficient markets, the fact is asset values are difficult, if not impossible, to quantify. They are rarely based on hard data, but rather what investors believe someone may be willing to pay in the future. Throw in uncontrollable and unpredictable macro incidents like war, terrorist acts, weather related events, new technologies and scientific breakthroughs that can alter investors’ perceptions. Any attempt to predict a bubble, let alone prevent a collapse, would mean preventing all of these kinds of shocks.

Those predicting bubbles rely more on art than science. Aziz noted in his article that even when analysts accurately predict bubbles, as Peter Schiff and Marc Faber did with the housing crisis, more often than not those same pros whiff in the aftermath. Schiff and Faber have both warned about a bubble in the stock market, treasury bonds, and the US dollar. So far they have been wrong.

If there is no way to accurately predict a bubble, how can one be expected to prevent one from bursting? Consider the current environment, where the US Federal Reserve has pumped massive liquidity into the US economy. Is that good or bad?

Without signs of inflation, one could argue that the Fed can print money as long as it wants. One could also argue that the Fed is buying treasury bonds, which represent debt that must eventually be repaid by the US taxpayer. Both points of view may be correct depending on the timeline being applied. They may also be irrelevant!

I see this firsthand when talking with clients. Double digit returns are expected on the back of bloated numbers from equity markets financed by central bank liquidity (note specifically the equity markets in the US and Japan). That’s not normal, nor can it be expected to continue indefinitely.

I also hear talk about alternative investment like mortgage backed securities that provide fixed returns with reasonable risk. But what is reasonable? Returns tied to higher risk leveraged loans backed by the belief that real estate will always rise? Sounds eerily familiar to the pitch used to sell mortgage backed securities in 2005!

But here’s the thing, and there is no way of getting around this, booms and busts are driven by fear and greed. And there is simply no way to prematurely predict shifts in sentiment.

So, if we cannot predict sentiment shifts, is there any way to contain sentiment? The answer is probably not! Investors could establish a personal portfolio benchmark that has historically delivered a satisfactory rate of return. But that only works if the investor is willing to focus on the long-term results rather than short-term aberrations.

For example, some years ago Professor Eric Kirzner and myself created a series of portfolio benchmark indices for the Financial Post. These became known as the FPX indices, of which there were three; Income (i.e. conservative), Balanced and Growth. You can read about how they were constructed at http://www.croftgroup.com/indexes/fpx.htm and you can review periodic returns using a benchmark calculator at http://www.croftgroup.com/indexes/calculator.asp. You can also review the periodic returns for the Mx Covered Call Index and the Mx Straddle Writers Index.

If we examine the results for last year, the FPX Growth Index returned 15.06%, firmly beating the less volatile FPX Income Index that returned 2.57% over the same period. But look at the numbers over the entire time; these indexes have been in existence and it paints a much different picture. In fact, the 18-year return from all three FPX Indices is virtually identical, which tells us that well-diversified portfolios get you where you want but take very different paths to get there.

That’s the rub. Investors want what is here and now without understanding the risks associated with short- term returns. That’s why financial advisors are always trying to dampen expectations in recognition of the fact that no one can accurately time end games.