Why Did Economists Fail to Predict the Crisis?

I think about it every day: "Why did so many investors have to be hurt by the financial crisis of 2008"?

In hindsight, it seems like the crisis was so obvious. The now infamous credit market debt to GDP chart, the parabolic Case/Shiller housing chart, the 40:1 leverage ratios, the subprime problems, etc. Weren't they telltale signs that something was profoundly wrong with the economy?

Perhaps not, but it's still astounding that we can count the "experts" who actually predicted the crisis on two hands. And many are even skeptical of this small sampling of prescient economists and analysts. Statistically speaking you could easily make the argument that most of these "experts" who got it right were anomalies or lucky. So why were so few investors prepared for the declines in the markets? I chalk it up to multiple flaws in the way investors have been taught to approach the investment landscape.

BusinessWeek recently described how wrong economists have been about the crisis:

In early September 2008, the median growth forecast for the fourth quarter was 0.2%, according to a survey by Blue Chip Economic Indicators. The actual outcome was a 6.3% annualized decline. The Fed didn't do any better. In July 2008, Fed officials projected unemployment in the fourth quarter of 2008 would end up between 5.5% and 5.8%. The actual number was 6.9%. Their projection for the fourth quarter of 2009, done at the same time, was for a range of 5.2% to 6.1%. Today, with unemployment at 8.5%, most forecasters expect the rate to be nearing double digits by the end of 2009.

But no one got the crisis as wrong as Wall Street's expert analysts. At the beginning of 2008 the average analyst was calling for $90 in total S&P 500 earnings. The final figure came in at $49.51. They missed by nearly 50%!

As I've mentioned repeatedly, the entire analyst community on Wall Street is flawed. Most analysts are selling a service or pushing a specific firm's long-term investment beliefs. This was well displayed in the 90's and despite regulatory changes, continues today. This is not to imply that all analysts try to rig the game (not that that doesn't happen), but for the most part they are pushing an agenda.

The most recent Bloomberg chart of the day shows how flawed this approach is. The most unbelievable part of this chart is not what Bloomberg points out (the first uptick in buys), but rather the total lack of sells. The number of sells on Wall Street has been below 5% throughout the duration of the worst financial crisis in 75 years.

That is simply staggering and borders on negligence, in my opinion. I routinely track a number of ETF's and individual stocks for my own portfolio and I will tell you that it is unusual to have more than 5% of the total stock market on my BUY list. While my buy list expanded markedly when I became bullish on March 8th, I still had an enormous number of sells. When I turned bearish at S&P 945 on June 1st, my sell list equaled approximately 95% of the entire stock market. Why was this so different from the 5% figure that the average Wall Street expert had on their sell list?

I attribute it to the tragically flawed and inflexible approach of most analysts. Wall Street banks sell financial products to investors. That's their business model. It is against their business model to slap sells on the products they sell. This creates an inherent conflict of interest and leads to perennial underperformance for investors who listen to their advice.

Even though many independent analysts have gone to great lengths to remove this conflict of interest it is too often clouded by flawed investment approaches. Analysts and financial advisors suffer from years of Efficient Market Hypothesis training. They've all been trained to believe that portfolios should be fully (or mostly) invested at all times and that buy and hold always wins.

This clearly is not true. I have long believed that markets are inefficient because their users are inherently ineffcient. Human psychology is incredibly inefficient. We are fragile and emotion animals. Markets challenge every survival instinct we have and unfortunately, when confronted with those survival instincts we often make irrational and inefficient decisions. Early March was a great example of panic filled irrational thinking. Unfortunately, analysts have thrived on EMH for decades. Then in 1999 it started to fail them....

Nassim Taleb is the analyst community's biggest critic. He recently said: "We have to build a society that doesn't depend on forecasts by idiotic economists." This goes back to our flawed system of thinking. Too many investors have been suckered into the belief that one investment approach is the best way to invest. Can you imagine if an Army General had ONE battle plan? Every war is different and requires a unique battle plan. Economic cycles aren't so different. Each cycle is different and each cycle is going to reward different assets in different ways.

But investors have been schooled to believe that you can apply one school of thought or one investment approach to each cycle. A classic response of late has been the Keynesian approach. Our politicians and economists have been trained for 50 years to believe that this one approach is applicable to all situations, but two years into this crisis we're finding that the classic Keynesian responses have done little to nothing.

Even worse, there is mounting evidence that this Keynesian approach actually contributed to the problems in the 80s and 90s. The same can be said of buy and hold for many small investors. Unfortunately, we've discovered over the last 10 years that buy and hold isn't always applicable. All economic cycles are unique and asset responses to each will vary widely. Investors need to learn that a multi-strategy flexible approach is the best approach.

Great economists generally differ greatly from other great leaders in one respect: they are rarely doers. Take the great military leaders of our history. What they all had in common was not only a great 6th sense for battlefield tactics, but they all fought in battles. They were great soldiers before they were great leaders. Too often though, our "great" economists and "great" analysts never spent any time in the trenches. They've never had a margin call, they've never been on the wrong end of a short squeeze and they've never run real money yet they end up making economic decisions that impact all of us in incredible ways. They suffer from a simple error in thinking: they can't connect the dots between theory and the real thing.

Ben Bernanke is perhaps the finest example of such a person. He has no formal banking background and has never worked at an investment bank. He is a lifelong academic yet he is selected to run the most important branch of the global economy. That makes very little sense to me. This is not to say that he isn't a phenomenally intelligent person, but if I am going to choose someone to fly my next flight he/she better have some hours in the cockpit rather than just thousands of hours reading the manual.

Getting back to psychology....Paul Wilmott, a quantitative finance expert once said: "Economists'' models are just awful. They completely forget how important the human element is." They too often fail to account for the unpredictable psychological element of markets. No model can predict human psychology. This is why quants are destined to fail. You can't create a mathematical model of human psychology that has any real predictive power. This is why risk management is so important.

Unfortunately, risk management is still a relatively undiscovered arm of investing. An example of good risk management in action was last September and October. I didn't predict the 2008 crash, but I did apply risk management controls that helped me avoid it entirely. On October 2nd I said that risks in equities were increasing rapidly because the TED spread and credit spreads were blowing out:

"Now, I’m not implying that the market might crash, but we certainly have all the ingredients"

This is where the "experts" fail. Rather than pull their troops back when the fighting got thick, most investors stuck to their classic investment approaches. It wasn't until the enemy was in their foxhole that they decided to cut and run (i.e., they finally sold at or near the bottom). It's not rational to expect the majority of investors to predict a crisis or economic collapse.

In fact, it's not surprising that only a handful of people predicted the crisis, but the fact that so much money was destroyed because of a total lack of flexibility and risk controls is a true tragedy. We can only hope that this crisis will change the investment landscape for the better and help to create a more intelligent and responsible class of investors.

For more on risk management please see here.

Disclosure: No positions

Comments

[Fighting Yoda:]

Yes the analysts and economists are in the pay roll of Wall Street brokerages, whose business model is ‘stay long’. Most investor are long only- institutions, pension funds, 401Ks, etc. Also Wall Street media is sponsored by these same brokerages, who in turn are obligated to be bullish. All this in addition to the American culture of ‘be optimistic’, ‘resilience of American consumer’, etc.

Analysts are always wrong especially on turning points, and these are points where you lose (some may gain) the most. So yes ignore the morons – their character and integrity and loyalty is in doubt – they serve their evil masters not the common investors. And they are not judged by the fact if they are right, they are simply judged by their ability to attract investment.

Jul 07 09:55 AM

[Teutonic Kn...:]

Economics is still much as art vice a science.

The closest related disciplines are perhaps finance, accounting and the so-called coined "Cognitive Sciences" coined by Prof. George A. Miller. So at best it is still a mixture of finance, accounting, psychology, philosophy, anthropology, linguistics, neurosicence, and computer science.

It is a very challenging field indeed.

Jul 07 10:09 AM

[axelrod608:]

SOME economists accurately predicted the crash. The pity is that the economists influencing current fiscal policy are the ones that got it wrong. Our institutions are still following the advice of those that got it WRONG and ignoring or heaping scorn on the ones who got it RIGHT.

Current public fiscal policy is straight from Hell. The idea that we can spend our way to prosperity is idiotic, moronic and just plain stupid.

Jul 07 10:30 AM

[Larry House:]

The Truth is always spoken by the few--not the masses. Some people just see the bright side of everything. When the market is going like it was just a few years ago, no one could or wanted to believe that it could do anything but continue to go up. Also, most investors are long-only investors. For the past 30 years, if you bought and held long enough, you made money. That may still be true if one has a long enough investment horizon. My point is that msot investors are not "wired" to do anything but buy and hold. So who is going to believe a few loonies who predict a market decline of major magnitude? And, the point that has been made is most valid: investment banks make money by pushing stocks. I was an account executive with a brokerage firm 30 years ago, and the motto was "I made money, the firm made money. Two out of three isn't bad." There is much truth there with only modest exaggeration. There was more concern for the client than that, but not a lot more. Calling a major decline and actually preparing clients for it is not in the vernacular of investment houses. Buyer beware.

Jul 07 10:48 AM

[Trend is No...:]

Read David Harvey's, A Brief History of Neoliberalism and then you will be a position to understand how economists have been de-skilled (Ivan Illich) and are taking on the role of 'academic entrepreneur' (Giroux); The construction of a consumer led economy did not erupt statutorily or legislatively from a vacuum; it was planned, executed, marketed and lamented after the fact with precision... The work of Walter Lippman and Edward Bernays is important here as it applies to mass marketing and manufacturing consent in behavioral economics... The premise of this article is really astounding; the economists failed to predict crises because they were either distracted by our bubble economy, lust for merit or were theoretically complicit and bent on replicating it....

John McElroy

Jul 07 11:02 AM

[socrateazz:]

I agree with much of what you say. What I would like to add is: The economy is formed by the collective decisions of the leaders over long periods of time. And the results of those decisions often are so far in the future that the actual reasons for economy changes are not often connected to the actual causes. For instance. I think the seventies inflation came about due to the sixties decisions. The ninties expansion was a result of decisions of the eighties. And the 2000's declines were due to 1990's decisions. That which happens during the 2010-2019 era will reflect decisons made this decade. I think most decisions made will make the next decade a depression. But we will see. I hope I am wrong. I think I could randomly chose 400 people from the streets and make them senators and end up with a better result than the elected senate does today! And many will agree with me.

Jul 07 11:28 AM

[Trend is No...:]

Spot on Socrateazz!; my only comment to your insight is that there exists a larger cohort trend in the economic and social engineering of Americans beyond decade analysis or smaller generational time periods. These trends include, as Arlie Hochschild points out, three elements which makes for the cascading of events (inflation, expansion etc.) accelerated. They are our social tendencies as a people towards: individualism, exaggerated sense of self related to work ethic, and materialism... Each of these issues serves as a buffer to prevent people (economists too) from really finding out what is happening and why

Jul 07 01:11 PM

[bigmoney:]

this one is easy ~ group think.

personality also factors in. There are perma-bulls (extroverted sales types), and perma-bears (introverted bookish types), but rare are those that can easily move between the camps as conditions change.

Jul 08 12:22 AM

[jeremyemilio:]

This is not a philosophical question; it is a math problem. The economists and market experts simply CANNOT predict crisis in the market because they ARE the market. If all of the economists see a crisis coming, they don't invest, nor do those taking their advice, and voila, no dot com bubble, no housing bubble, no stock market bubble, no crisis. The trouble is, the question then gets spun around: "Why did the economists predict a crisis that never occurred?" To put it another way, the crisis isn't something that occurs in a vacuum, isolated from economic forecasts... it is a SYMPTOM of economic forecasts. I.E.: The crisis wasn't unforeseen by economists wearing rose coloured glasses; it was CAUSED by economists wearing rose coloured glasses.

Jul 08 02:18 PM

[Gregman2:]

Answer: altitude sickness due to over exposure to the ivory tower.;-)

Jul 08 07:31 PM

[perceptions...:]

"We have to build a society that doesn't depend on forecasts by idiotic economists."

We could simply adhere to some basics, one of which would be, not to reward failure!

Jul 09 01:30 AM