Is Financial History Bunk?

Henry Ford said it first and best, “History is more or less bunk.” Is financial history any different? I ask myself that question a lot lately, almost every time I read something where the analysis compares the current “recession” to the average of something in a prior recessionary period.

For starters, there are precious few prior periods, with less than a dozen downturns worth the name in the last century. So we’re already working from a tiny sample size.

Second, there are oodles of reasons to expect that such situations are closer to unique than analogous. Is the previous example a recession? A depression? Was it in the U.S.? Where were rates going into it? Was it consumer led? What was inflation at the outset? Where was unemployment? What triggered the downturn? What was consumer debt load? I could go on and on, but you get the point I’m sure: History is awfully flawed as a guide for what is going to happen next when you’re dealing with small sample sizes and when inter-period situational variance is so high.

So, why do it? Why talk about which sectors lead in/out? Why mention that this is the best two-day week in modern market history? Why talk about the length of typical recession since WWII? Why go to any of those lengths? In part because it makes people feel better, which is nice; in part because it gives market analysis the patina of a science, which is wrong but also nice. And, yes, there is also that sometimes there is even some validity to it -- that, all else being equal (which it rarely is), we might get things to unspool in a similar way this time as they did the last time something like this happened.

The risks of financial history are higher than ever though. We have more data, better analytical tools, and more people crunching the data, so we can expect to see data on pretty much anything we want to see. There will always be someone tearing apart something to find something interesting, so something interesting will be found. My friend James Altucher has always been great on this subject, ripping holes in pretty much every data-driven rule of thumb by which people claim to trade and/or find market tops and bottoms. They mostly don’t work.

Anyway, I’m torn on the subject, but I’m also increasingly skeptical of any and all comparisons to prior historical periods. I don’t buy trough P/E, or recession length, or relative valuation, or interest rate, or sectoral rotation arguments, or… you get the picture. I love data, but I’m increasingly close to being an outright nihilist when it comes to over-reliance on historical financial data without any truly coherent supporting rationale. We are in a grand experiment with no real history to draw on, and anyone who pretends otherwise is deluded or selling something, or both.

Thoughts?

Comments

[Alan von Al...:]

Paul, it's always refreshing and enjoyable to read your latest. We're in uncharted territory. The scale of "fire brigade" Fed-Treasury bailouts and forthcoming fiscal stimulus is unprecedented. Ditto global CDS, MBS, bank leverage, unsecured consumer debt. I have my doubts about the historical comparability of employment and inflation data, too.

Jan 05 11:07 AM

[Jolly_Rancher:]

As long as the relationship between variables (i.e. cause and effect) is logical for the situation, the forecast should be good enough to outsmart most investors. For instance, the dramatic rise in oil to $147 should have warned you to stay out of the auto sector. Combined with the crash in housing, you should have known to stay out of stocks all together, at least as of January 2008. Now suppose most people with SUVs trade down to very fuel efficient cars or move closer to work before oil prices sky rocket the next time? At that time housing will probably not be the primary concern. What will be the issues? These are the types of things to consider. Econometrix is not a substitute for logic, but is a tool. Cause and effect must be determined in advance or with the help of econometrix.

Jan 05 11:12 AM

[pacalis:]

As much as I think it is important to call out for more theory, but why must financial history be only US financial history? I for one would love more analysis comparing US economic conditions to other countries historical conditions. The US already suffers from too much navel gazing in international affairs.

Jan 05 11:22 AM

[Moon Kil Woong:]

I enjoy re-assessments of the past recession. By and large, I think the data points, facts, etc. of the past are often misread and misunderstood. Unemployment numbers today don't reflect the past, inflation numbers have been tampered with. When people said China on the silver standard fared better than the rest of the world I want to puke. There is no uniform, tamper free international economic reporting system or anyone to monitor compliance.

Today, all governments tend to play with fudged numbers. Comparisons are largely apples to oranges. What can be said about the recession is that for one reason or another the public all over the world lost confidence in the value of money leading to bank runs, etc. I tend to believe with Steve Hansen the hand that protectionism and global trading dropped as a symptom of this rather than the root cause.

Can I say I am definitively right and they are wrong? No, but the mental assessment is valuable in trying to understand future crisis' such as the one today. This is not just to make money but also very academic.

For instance, government action to increase money, make credit cheaper, raise money, increase jobs, etc. may actually compound a growing unease that decisions are haphazard, random, and unpredictable leading to more consumer discomfort and more conservative actions by businesses. Stability and clear market indicators are more critical than any stimulus could be. Even if those indicators are not good, it is better than nothing.

WWI was not a good indicator but it was a very clear indicator. It said, hey we are going to spend in this category, and keep doing it until the war is won. Businesses adjusted to it and everything fell into place. Given war is artificial demand, however, it is consistent and predictable in its nature.

Can we say bank bailouts are consistent and predictable?

Not really. If you ask my opinion, I think unobstructed transparent and consistent economic metrics unfettered by government and political manipulation is very key to understanding the economy over a long term and it's shameful that the legacy of past data has always and looks to always be mired in manipulation.

Also economics and psychology go hand in hand. Simple solutions like if we make more money deflation will be slayed is simplistic and revolutionary in it's stupidity. The reason for this is that people will increasingly loose faith in the currency and will flee to assets causing mass inflation. Sure it works to tweak the economy, but not to pull us out of a deep dark deflationary spiral.

The only rational thing is to restore confidence by creating stability and directing business towards economically viable future growth, not by shoving money into banks pockets and saying if you want more lend it to whoever.

When we look back a few hundred years from now I think they will say that our economic history today mirrored a fairy tale story. It has some truths, but is completely lacking in being the least bit realistic.

Jan 05 11:27 AM

[Alex Filonov:]

Mark Twain said "History doesn't repeat, but it rhymes". I can't say any better.

Jan 05 11:46 AM

[mbborak:]

I think this article reflects the author's frustration with the impossibility of finding a neat historical reference point that explains the present market conditions and predicts a future outcome. Certainly, many out there in the financial press try to oversimplify current and past recessions into "narratives" that can be easily understood in one concise (and easily published) article. The expectation that we can simply point to a previous recession and say "ditto this time!" needs to be put to rest.

History can definitely lend insight into the current market turmoil, but because we are in the middle of it and have so far seen outcomes that were largely unexpected, the instinct is to throw our hands up and say that history has failed us. I simply cannot believe that there is nothing to learn from past events in our financial history, and I would argue that up until the Fed and Treasury started their meddling, a prudent financial historian could have largely predicted the onset of this recession (and several did). The picture is certainly cloudy and there are no easy answers. To echo Mark Twain, history gives us clues, not prophecies.

Jan 05 12:21 PM

[prudentinve...:]

Excellent and thoughtful article. I guess you're suggesting that one rely on one's instincts or gut feelings, rather than succumb to sensory overload. If that's what you mean, I agree wholeheartedly.

Jan 05 12:24 PM

[22percent:]

Amen brother!

Just think how much meteorological data we have collected over the last 100 years, but still we can't predict the weather 5 days out with any real accuracy. Yet, from just one single set of inputs for global economic history resulting in one unique historical output, we're suppose to be able to determine that the likely length of a market trough!

I would encourage the doubters to read Taleb.

Jan 05 10:37 PM

[Ferdinand E...:]

"Econometrix" can enable you to determine cause and effect, the Jolly_ Rancher said. I taught econometrics and worked with it for 3 years in Geneva (Switzerland), and used it in my early books. To paraphrase Henry Ford, a large part of it is more or less bunk, and many of the persons who resort to it are useless. There are, probably, a few practitioners of econometrics who have something to offer, but never...never have anything to do with the rest.

Jan 06 10:01 AM

[svkoho:]

As usual from Paul, a useful insight and spot on. The economic history of the industrial revolution is so short with minimal appropriate data sets. I think history is a useful knowledge base but economic history in this country is fraught with traps and potholes. Economists are experts who will know tomorrow why the things predicted yesterday didn't happen today.

Jan 06 10:15 AM

[OldLimey:]

Great article and interesting comments. I tend to the view that the broad sweep of history has much to teach us, but that its finer nuances are too dependent upon unique combinations of circumstances, actors, and actions to be a detailed guide to the future. Too often, history is manipulated for use as a weapon rather than analysed as an aid to understanding.

Jan 06 02:33 PM

[Boubou:]

I agree with this assessment.
The past is a good guide to the future in matters such as astronomy where, over a short enough reference period, for example, you could reasonably expect the sun to rise roughly in the east.
This latest situation has enough unique features to make simplistic references to the past almost uselss.
And yet, many expert blogs present exactly that , replete with ingenious charts derived from past cycles.
Even in the most 'normal' of times its obvious that no sage can predict the future of any asset. If there were such a sage, then the whole casino would be closed in a week.
Of course IN RETROSPECT, up to half the sages were right in any given prediction, and at least half wrong, but that doesn't make any of them a sage.

So where do we go from there? We're the blind leading the blind.

Jan 06 02:58 PM

[Boubou:]

Furthermore, given the morass of unpredictability, those in the field , such as economists and fund managers who have to make statements , have to grasp at any straw to give some apparent support to a viewpoint - to get a 'slant' going. The past is one of the only straws going.
This is what is interesting about Paul. He just let go of the straw.
A propos, they say the astrologers newsletter is about the best for the last year.

Jan 06 03:11 PM

[carey_jim:]

You said, 'Anyway, I'm torn on the subject.'

If you were hiring someone to do a job, you would look at his/her resume and make certain that it reflected the truth.

But then again, you would look him/her in the eye and ask a few pertinent questions, and if you really liked him/her and his/her answers you would probably hire him/her whatever the resume said. You would find excuses and reasons for past failures.

It's the same with history, isn't it?

Jan 07 12:25 AM

[morph366:]

A very good and provocative article, aided by its brevity.
Question that comes to mind is perhaps even broader than issues of financial history - what kinds of narrative are required for societies and economies to be managed properly? Living in such a complex, inter-dependent and inherently unstable world it is not too surprising that we gravitate towards simplifying narratives like "average recession length", "fundamental value" and "reversion to the mean". We just have to be aware that they are narratives and not mathematically important theorems about the way that the real world works.

Jan 18 10:56 AM