Predicting the Next Big One

In Seeking Wisdom: From Darwin to Munger, Peter Bevelin has an interesting take on the frequency of extreme events:

Statistics shows that the frequency of some events and attributes are inversely proportional to their size. Big or small changes can happen but the bigger or more extreme they get, the less frequent they are. For example, there are a few large earthquakes, fires, avalanches, or cities, but many small ones. There are a few billionaires but many millionaires.

The size and frequency of these events and attributes has a statistical pattern — a scaling relationship that is about the same independent of size. For example there is a scaling relationship between earthquake magnitude and frequency. Based on observations from 1990, U.S. Geological Survey estimates the average annual frequency of magnitude 8 and higher earthquakes to 1, magnitude 7-7.9 to 17, magnitude 6-6.0 to 134, and magnitude 5-5.9 to 1319 earthquakes. Still, the patterns are based on past statistics and estimates. They don’t help us to precisely predict future events. For example, catastrophes occur randomly. We don’t know when the next big one will hit.

There are obvious parallels to the financial markets here. You can look back at the past 100 years or so of financial market history and come up with a bunch of different averages or indicators to show how things have played out in the past. But anyone relying exclusively on that playbook will continue to be surprised again and again as history never repeats itself. Average is a rarity in the markets at any given time.

Investors are constantly using those historical inputs and their own memories to make current decisions so the markets are constantly evolving. I’m always surprised by how investors can have completely different takeaways from extreme market events depending on their world view and experiences.

The S&P 500 chart since the tech bubble popped in early 2000 tells quite a story…

SPY 2000

…but that story gets interpreted in many different ways.

One of my biggest lessons learned from this cycle is that anything is possible in the markets. Certainty is rarely rewarded, and even when it is, it doesn’t last long. The massive swings in these cycles go much further and last much longer than I would have thought possible.

Others seem to have their own takeaways from the past decade and a half. If anything, it’s emboldened some to believe that they’ll be able to predict when the next huge crash will hit. Living through two market crashes has amplified the hindsight bias for many investors.

I’m not sure what, if anything, this means as far as how the next bear market will play out.  But I have a feeling investors will surprised by when and how it transpires. When things do eventually head south and this giant bull finally takes a breather, you can be sure that panic will set in because people will still be caught flat footed. I can’t remember where it came from but one of my favorite quotes from the past few years is, “never be surprised that you’re surprised by the markets.”

I know that there will be more market panics and crashes in the future, but I continue to believe that it’s a waste of time to try to predict the tops and bottoms. It’s just asking for the markets to play mind games on you. No one knows when the next big one will hit. Yet I don’t think that will stop investors from trying to figure it out.

To quote Jerry Seinfeld, “Good luck with aaaaaall that.”

Source:
Seeking Wisdom: From Darwin to Munger

Further Reading:
Market Earthquakes
Buying Insurance After Disaster Strikes

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What's been said:

Discussions found on the web
  1. ResilientMan.com commented on Aug 07

    “No
    one knows when the next big one will hit. Yet I don’t think that will stop
    investors from trying to figure it out.”

    Let me give it a shot 🙂

    There is a split between
    commodities and equities, a drop in commodities means a drop in demand, which is a fundamental driver. The other possibility that commodities have become more abundant, which might be the case in some areas but not in all.

    When I see the markets at these price levels and with other factors such as P/Eratios, low interest rate (which encourage own stock purchases by the firms) .. one has to have and take a step back.

    Individually, it might me a shame to miss on the rally. What do you think about collectively? If each individual has blind faith in the markets, there is no price discovery mechanism any more, the only way is up.

    • Ben commented on Aug 07

      Commodities are tricky because it sure seems that this is less driven by economic fundamentals and more about technological advances. But who knows? Like you say, could be a combination of both. My take is there’s a pro for every con right now:

      http://awealthofcommonsense.com/seeing-both-sides-of-the-market-debate/

      The biggest problem for investors is that so many are predicting only extreme outcomes. I’d be much more secure making a prediction for a 10 to 15 or even 20% drop than a huge crash. It’s just more likely to happen. Always interesting…

  2. John Coumarianos commented on Aug 07

    Actually, that chart doesn’t tell me “anything is possible.” That chart tells me when you bought the S&P 500 at nosebleed prices in 2000 you made 90% in 15 years — or less than 5% annualized. In other words, you didn’t do very well. And you endured a lot of volatility along the way.

    Funny how the chart’s last surge makes it seem like you’ve done incredibly well over the entire 15-year period….. You haven’t. And you shouldn’t have, buying at a Shiller PE of 44. (Not implying any nefarious intentions by showing the chart though….. Just offering a different interpretation….)
    In fact you required a massive surge over the past six years just to get that 4.6% or so annualized over the whole 15-year period.

    So….. the chart tells me if you buy at high valuations, you lock in poor returns for a long time…. And endure a lot of pain from volatility.

    That’s a pretty different lesson than “anything is possible.” Only by presenting the chart without any reference to valuation can you arrive at that interpretation….

    Prediction is really hard, granted…. But maybe it’s less hard than normal at a 44 Shiller PE…..

    Sorry, just calling it as I see it….

  3. John Coumarianos commented on Aug 08

    Also, standard deviation of returns for the period shown in the chart: 18.6. Standard deviation for the index from 1970 through 2014? 17.2.

    Surprising, isn’t it?

    There really wasn’t that much more volatility for the 15-year period in the chart than there was for the 45-year period starting in 1970. Nothing to see here, really, from a volatility perspective…..

    We all think we live in the most volatile, interesting time. And that thought cows us and makes us bow down to the idea of the randomness of things. But all that’s become a little overdone…. Just normal stock market volatility here…. It was 1980-2000 that was abnormal.

    Not many people remember the 1970s, and too many people only remember 1980-2000, which was unusually calm for the markets.

  4. jz commented on Aug 08

    The S&P chart above is fabulous, customized beauty for anyone planning to retire in 2015.

    • Ben commented on Aug 09

      It’s definitely going to be a tricky environment for retirees from these levels and interest rates. Hopefully they’re squeezed out most of the returns from the past cycle.

  5. Keith G commented on Aug 09

    Ben,

    For me, the chart emphasizes the need to diversify and rebalance. When you diversify your investments, hopefully you can lower your overall volatility, and hedge against a major decline in any single asset class. The act of rebalancing is forcing function to buy low and sell high (relatively speaking)

    While I agree that it’s fool’s errand to try to call market tops and bottoms, I do think it is prudent to adjust our expected returns as the market rises and fall. So as market moves higher, expected returns should be lower and as the market falls, expected returns should be higher. So the smart thing to do is increase your stock exposure in a down market and decrease your stock exposure in up market. Of course the evidence shows that very few investors (individuals and professionals) actually behave this way.

    Keith

    • Ben commented on Aug 09

      Well said and I completely agree. Setting realistic expectations is one of the most important aspects of a solid investment strategy.

  6. Bob Carlson » Predicting the Next Big One commented on Aug 10

    […] recent history of the last two crashes for indicators that will help them forecast the next one. Here are excerpts from an interesting discussion of efforts to predict the next big one. I like it, because the […]