Wisdom of the Ages

In many fields, those who've been around a while are often seen as old coots who are totally out of touch, unable or unwilling to adapt to what the up-and-comers say is a new reality. The same holds true on Wall Street, especially when it comes to old-timers' views on money-related behavioral foibles and risk-taking.

However, one individual whose tenure goes back a long way, but whose insights always sound refreshingly contemporary, is Peter L. Bernstein, financial consultant, economic historian, and author of the investment classic, Against the Gods: The Remarkable Story of Risk.

In an International Herald Tribune column, "To Botch an Economic Forecast, Rely on Past Experience," Mr. Bernstein offers one reason -- among, in my view, many other, less charitable explanations -- why so few individuals anticipated the unsettling events of this past year.

A lot of people have been wrong about the markets and the economy in recent months. But how could so many people have been so wrong at the same time and in the same ways?

The question reminds me of the biggest and most embarrassing goof in my own career. This sad story happens to date back 50 years, to New Year's Day of 1958.

In looking back, I can now see the source of my error: I was postcasting - extrapolating past experience instead of seeking change in future experience. The aftermath was embarrassing, but it taught me never to postcast again.

I had been invited to make a presentation on the outlook for 1958 at a symposium at the Harmonie Club in New York. The program was to take the form of a debate with another economist whose view was diametrically opposed to mine.

Although I was extremely bearish and would look mighty silly within six months of the debate, I was the one who swayed the audience. It voted overwhelmingly for my position and scorned the wisdom of my opponent.

There was no doubt that the new year was dawning at a dark moment. The stock market had peaked in August and was already down 13 percent. The Christmas season had been a clear disappointment. Industrial production had fallen 6 percent from its August high. Unemployment had jumped to nearly 6 percent from 4 percent the previous summer.

We could all agree that a recession was in the making. The issue was how deep the downturn would go and how long it would last, and this was where my opponent and I parted ways.

He expected the recession to be short and sweet, with a revival in the economy by summer at the latest. I saw no sign of light anywhere. A child of the Great Depression, I had been well schooled by my college professors in economics in the late 1930s to believe that the American economy had lost its long-run dynamic. So, in the downturn of 1957, I was convinced that the dreaded moment had arrived when we would sink back into the stagnation of production and employment that I had remembered so well.

But how could I have failed to notice how many things had changed? The dynamic power of the American economy was visible everywhere. The population had grown 19 percent since 1947, compared with growth of only 7 percent from 1929 to 1939. Houses were sprouting up all over; there were new kinds of cars, new kinds of airplanes, new kinds of radios, and, above all, television was a reality. All of Europe was coming to our shores to find what it needed to rebuild after the destruction of the war; in real terms, our surplus of exports over imports had quadrupled since 1929. The United States sat on a huge pile of gold, and liquidity and consumer credit were easy to come by.

Indeed, when I spoke on that New Year's Day, the economy was within six months of touching bottom and would be hitting new peaks by the next New Year's Day. As it turned out, most of the recession of 1957-58 was a result of a runoff of excessive inventory accumulation rather than a failure in underlying demand.

Most surprising, price levels were firm, although prices had always declined in previous recessions. The stock market would touch bottom within days of my dismal speech and would rise so fast that the dividend yield on common stocks would fall below the yield on long-term Treasury bonds. This was an unheard-of event, but one that has never come close to being reversed. Of all developments, the unexpected break in stock market history was the most auspicious sign of faith in the future.

I look pretty stupid in hindsight, although I remind you that I had plenty of company in the audience that day. How could so many people be so wrong?

The same question applies to the turmoil of the present as we approach another New Year's Day, and it has applied many other times in the past half-century. As we have learned again and again, we seem to have great difficulty recognizing a changing environment (though it looks so easy in hindsight).

Humans cling to early experiences and what they have understood, even when something different is directly in front of them.

From the end of 2002 to the early months of 2007, prosperity seemed firmly rooted and even touched by some kind of magic. The Fed appeared to have inflation under control, productivity was high, no squalls were hitting the stock market, the dollar's decline was orderly, home prices generally rose steadily, and the unemployment rate fell in many months.

Even better, investors could buy all those interesting new forms of financial paper invented by the engineers, offering high yields at what the rating agencies assured investors was low risk.

But the magic was not in concrete; it never is. The conviction that risks were low led investors to take greater risk without requiring higher expected returns. By late 2006, the Fed was wrestling with inflationary pressures from oil and food, productivity had lost its momentum, housing prices had been declining since summer, and the mortgage markets were starting to crack.

Nevertheless, like me in 1958, investors refused to see the ground shifting beneath them, even though the environment was no longer what they knew and thought they understood. Like me, they were walking into a trap where the responses were not what they had anticipated. Like me, they were headed toward big surprises for which they had no preparation.

It has been said that good forecasters have a good sense of history. I suppose that is true. But the best lesson from the past is to forget it before it shoves you into trouble - and remember that surprises and ruptures surely lurk ahead.

Comments

[Contrarian Investors' Journal]

I like it when Bernstein said,

"It has been said that good forecasters have a good sense of history. I suppose that is true. But the best lesson from the past is to forget it before it shoves you into trouble - and remember that surprises and ruptures surely lurk ahead."

I would like to include some additions from this article at http://cij.inspiriting.com/?p=341:

"The root to the understanding of this paradox is this: It is not experiences (which include borrowed experiences from the study of history) that trip us. Rather, it is how we apply our experiences that lead us into fallacies."

Although Bernstein did not mention Black Swans, this is the concept that his article alluded to.

[deborah]

I had the occasion to talk with a financial agent in his 30s this week that claimed that what I saw as disastrous changes as changes for a new reality and economy.

The disastrous changes I saw was my Canadian bank offering zero down mortgages. Much to my dismay our law has changed in the past year to allow this...

So much for Canada avoiding its own mortgage crisis because of responsible lending practices...

[bob niederman]

"investors could buy all those interesting new forms of financial paper invented by the engineers, "

Please stop calling these swindlers "engineers". Engineers find new and/or less expensive ways of creating things with some value. Wall Street just found new ways of lying to cheat people out of money.

[Steve]

Wisdom, indeed. But I wonder what the message is for the current times? If ever there has been a highly covered and highly discounted event, the subprime crisis is it. It's interesting that the panic bottom, representing fear of the completely unknown, achieved Aug. 16, is about the same as the knowledgeable bottom, reached in November, after many facts about the crisis had been revealed. The fact is, most of the writing featured in this blog lately is of the rear view mirror variety. I agree with Mr. Bernstein. Today, as in 1958, it's not easy to see what's changed. I talked last night to an old college roommate (of 1972 vintage), who had traveled to Bhutan via Bangkok. His striking comment: there are more skyscrapers in Bangkok than in NYC (an impression, but an interesting one). So yes, Mr. Bernstein, it's easy to be compelling when being erudite about the recent past. But seeing what's ahead? That's not a power we're blessed with. To quote one of my favorite entertainers (who masqueraded as a stock market prognosticator), "If it's obvious, it's obviously wrong!" Alas, though true about what's wrong, it says nothing about what might be right. I look forward to another fun and surprising year.

[D.D.Grant]

What I have yet to see, (in today's info rich world I could have easily missed it), is a real analysis of the chain of liabilities in the credit world. This is essential if a judgement is to be formed of the notion that the global liquidity pool is of such a size and structure that it is sufficient to dissipate the resonation of projected levels of default. Either their is a critical fracture point where the accumulation of the effects would be such as to precipitate a catastrophic series of failures or the global markets are such as to preclude such.

Intuitively the conclusion is that there cannot be this type of resilience. Either the 'new globalists' are correct in asserting this 'something new' or our earlier understanding holds. Is the "Straw that breaks the camel's back" principle still valid or not?