In this modern age, we have unprecedented access to information. Yet humanity’s knowledge limitations are daunting, despite our belief that we know just about everything.
Prior to the financial crisis of 2008, “financial industry experts” failed to recognize the mispricing of almost every asset class on the planet. But 2008 was not an exception. (See Recommended Reading, below.)
History proves that predictions regarding market dynamics are mostly conjecture. So, too, are theories about the effects of globalization, the impacts of geopolitical events, and the ultimate black box: human behavior.
Despite our fallibility, investors are subject to an endless torrent of conflicting viewpoints and head-scratching (but often, shrewd) economic prognostications. Surely, not all commentary represents misinformation. But whether it arrives through honest debate or infomercial (to sell advertising, securities, professional services, or even a personal brand), the net psychological effect is a sense of knowledge. The illusion of fact.
What a history of predictive failures should suggest is that nobody can be sure that a global financial crisis won’t happen again. To the contrary, there is sound reasoning behind the idea that the global economy has yet to emerge from the Great Recession; that we have not yet adequately addressed the root causes of that event. Consider the following observations, adapted from economist David M. Smick’s 2017 book, The Great Equalizer:
With the exception of increased bank capital “safety nets”, much of the pre-2008 global financial architecture remains in place today. Collateralized debt obligations—the financial instruments that disastrously collapsed in price during the crisis—are still sold in private placements with confidentiality agreements, while the credit rating agencies (the same institutions that overlooked the risks in the period leading up to 2008) remain in operation.
Simultaneously, ongoing monetary policy experiments compel individual investors to purchase relatively risky assets that they would have never considered if the rate of returns on their money market funds and savings accounts had regained their higher, historical levels. To survive, average investors, including the elderly, have had to move further out onto the risk curve, just to achieve enough of a financial return to supplement pensions and Social Security payments.
Still, and lacking alternative investments elsewhere, today’s global ocean of capital continues to pour into the U.S. financial market. This flood drives U.S. market interest rates lower (or keeps them from rising), while stock and real estate prices have risen to levels far higher than many experts anticipated.
These ideas represent just one of many narratives (albeit one that we subscribe to) challenging the popular expectation of increasing rates. It is prudent and rational to believe interest rates will rise, but with history as our guide, nobody can say when and by how much. Nor can they say with certainty that rates will not fall before they rise.
Importantly, investors must consider the opportunity costs associated with acting—or not acting—on the “conventional wisdom” that forms around us. Ask an investor who has been waiting for the arrival of higher interest rates since 2008, whether they would have preferred to be fully invested over the period since the crisis. Then, ask if the economic chatter from informed “experts” influenced that decision.
Ultimately, investors must acknowledge that some things are unknowable. As Mr. Smick observes, we must be reminded that “the best Wall Street financial traders are wrong nearly fifty percent of the time…[A]nd most have high-priced research departments to back them up.” It may be tempting to believe otherwise, but no in-house economist can overcome this inability to see or model the future. The past is difficult enough.
What we must be able to do is identify the unknowables and design investment strategies that can survive, while expecting the unexpected. At some point, the rate picture will change. But no one can predict when… nor if and when the next trauma to our financial system will occur.