Future Proof.
The first step of planning for the future: avoid sloppy logic.
Predicting the future is hard. To do so accurately seems impossible.
But we all plan for it.
Planning for an impossible to predict future isn’t easy to say the least.
But try we must.
One way to make such an impossible task easier is to avoid blatant errors of logic.
This is especially important when it comes to the markets.
Why do the markets matter so much anyway? Can’t we just write about iPhones and Twitter?
Whether we like it or not, the global economy, and thusly much of our daily lives, is now firmly tied to the direction of the financial markets.
Said differently: if markets break, the real economy actually gets hurt.
We saw this clearly in 2008, when the crashing global markets caused the global economy to go into a recession, not vice versa.
This seems counterintuitive: the markets should reflect our expectations about the future, so why would the causation flow like Markets → Economy, rather than like Economy → Markets?
There are lots of reasons for this, but the primary ones seem to be the globalization of finance and our reliance on credit.
Said differently, the economy relies a lot on borrowing, and banks that do the lending are interconnected with one another because they invest in the same securities. So when markets go south, this cripples banks, which cripples lending, which slows down the economy.
When the housing market and the global credit markets came crashing down in ‘07-’08, lending dried up, and the real economy came screetching to a halt.
Why am I being such a downer by bringing up this stuff now anyway?
Isn’t the U.S. economy doing better and aren’t we finally making our way out of the global recession?
Fortunately, the answer to both of those questions is: Yes!
And that is awesome.
But, there is a risk looming on the horizon with implications that are scary enough to talk about. And do our best to plan for.
But first, let’s clear up some sloppy logic that people use way too frequently when talking about markets.
Nassim Taleb, as quoted by Dylan Grice, highlights the issue here:
A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So, with the butcher surprising it, the turkey will have a revision of belief—right when its confidence in the statement that the butcher loves turkeys is maximal … The key here is such a surprise will be a Black Swan event; but just for the turkey, not for the butcher.
We can also see from the turkey story the mother of all harmful mistakes: mistaking absence of evidence (of harm) for evidence of absence, a mistake that tends to prevail in intellectual circles … “Not being a turkey” starts with figuring out the difference between true and manufactured stability.
…As Taleb shows, this is a straightforward if fundamental logical error. It has also led to fundamental problems in the past.
For example, it was said that there was no “inflation” during the US housing bubble (because artificial increases in house prices didn’t count). It was said there no “inflation” during the technology bubble (because artificial increases in technology shares didn’t count either). It was even said that there was no “inflation” as what was arguably the biggest bubble in financial history inflated, that of Japan in the 1980s (the Japanese called it the babaru).
Said differently, the fact that something has not occurred in the past does not mean that it will not occur in the future.
There are many things that have never happened, and if some of these things do occur, the implications are scary.
One such scary thing has already started to materialize: that is a rise in interest rates and the implications this could have for individuals who are invested in bonds and bond funds.
One of the scariest things about this risk is that even smart people like the folks at Vanguard make the logical error cited by Taleb when analyzing it. (Not to pick on Vanguard, most people make this error).
In a report published this April, subtly entitled “Reducing bonds? Proceed with caution”, Vanguard analyzes a variety of scenarios to make the point: if stocks fall and bonds don’t fall as much, owning bonds reduces the impact of falling stock prices by providing diversification.
Almost all of the scenarios analyzed assume that bond returns will be positive (because they were in the past). The “worst case scenario” analyzed in the report considers what would happen if bond prices fall ~9%. The report cites the 1970's as the only time this has happened, implying that even this case is unlikely to happen again.
However, the scenario they do not consider seems more important to keep in mind — if interest rates rise significantly more than they have in the past, bond prices could fall way more than they did in the past.
The problem with their analysis and with all analyses based on historical data alone is that they are by definition subject to the error Taleb and Grice mention above.
The fact that something has not happened yet, does not mean it will not happen in the future.
Just because Treasury yields have never risen by 5%, while the stock market also rises, does not mean that will not happen.
And in fact, if we look at what has occured since Vanguard published the report in April, this scenario has been playing out:
Since May 1st, the Vanguard Total Bond Market ETF is down ~5%, and the S&P 500 is up ~7%.
What happens if this continues? What if the bond market continues to fall and people who can least afford it (retirees and others who are holding bonds because they are considered “safer than stocks”) lose money by holding something they were told was safe?
What about the implications for bank lending if “safe” assets decline in value again? Or what does it mean when China’s largest holdings (Long-term US Treasuries) decline in value?
None of us can predict the future accurately no matter how we try.
But we all must plan for the future, and in so doing we should consider the risks associated with outcomes that might happen — even if they haven’t happened before.
And we should plan accordingly.
Considering the impact that rising interest rates might have — even considering scenarios that have never happened before, like where rates rise a lot more than we assume they will — seems to be a prudent thing for all of us to do.
Knowing all of the implications of such a scenario requires a crystal ball clearer than any of us has. But preparing for it seems prudent.
