How to Spot a Crisis

Man, I didn’t see that coming. Ever said that before? I have. September 2008. Right after AIG went down – and this was six months after Lehman Brothers’ BK and the S&P 500 touched 666 on March 6, 2009 (for comparison, the S&P stands today at 2,450). So, I should have been on notice to say the least.

Like a lot of people, I thought we were riding through a short-term problem that might hurt a few firms, but would be isolated from the overall economy.

Nine years later, it’s easy to see how wrong I was. This was a crisis that rolled through the economy and we are still experiencing shockwaves from it in regulations and investor behavior.

Could I have seen it coming? Could I have predicted the crisis? Can anyone? I think the answer is broadly “yes”. So how does one go about crisis spotting? I suggest the following three steps:

  • Develop a crisis-spotting mechanism
  • Develop a current hypothesis as to the risk of crisis based on your spotting mechanism, and
  • Challenge and review your hypothesis regularly
  • The point is to be aware of the conditions that can lead to a crisis and to inform your business strategies and appetite for risk accordingly. To be clear, we are not talking about market timing but rather creating a reliable mechanism so that you are aggressive and conservative at broadly the right times – and ready to respond when conditions meaningfully change.

    So what is a crisis? I define it as pronounced and perhaps sudden economic downturn caused by problems with liquidity, credit, currency and/or employment although this is not an exhaustive list. Although a recession or moderate economic downturn is not a crisis per se, your spotting mechanism should still pick this up.

    So, here’s how I go about trying to spot a coming crisis in four easy steps (with a look at some of the data I follow):

    1. Start with the Macro

    Aging Economic Expansion

    Where are we in the business cycle? It’s easy to dismiss this simple indicator as obsolete – and I will concede that “recent” (as in the past decade) unprecedented monetary policy has perhaps extended the business cycle – but it is still very relevant to crisis spotting.

    The chart shows how far we have moved from the cataclysmic days of 2009. The economy is expanding and we are seeing the growth in jobs and wages (mostly) we expect from this stage of a recovery.

    The next stage is the inevitable slowing as the process moves into the next phase everyone dreads: a recession. Since WWII, the length of these cycles has been 69 months with expansion taking up an average of 58 of those months, leaving 11 months for the average recession. Note that the current US expansion is 96 months old making it the third longest expansion in history.

    Business Cycle Assessment: Above Average Risk of Crisis

    2. Develop a View on Interest Rates

    If rates are a risin’, there’s trouble on the horizin’. Seriously, the level and future path of interest rates is probably the single biggest factor in crisis spotting. Warren Buffet recently stated that “if interest rates stay this low, stocks are cheap.” In other words, the level of interest rates dictates asset valuations. This statement could apply to many other asset classes such as commercial and residential real estate, for example. The takeaways are that the general level of interest rates greatly affects financial asset valuations, valuations are a key factor in the development of asset bubbles and asset bubbles (eventually) lead to crisis.

    Don’t fight the Fed: After years of historically low rates, the Fed is in a tightening cycle:

    ..And they are shrinking their $4.5 Trillion ($4,500,000,000,000) balance sheet:

    “Fed Unveils Plans to Shrink Its Balance Sheet”

    – The Wall Street Journal, June 14, 2017

    Yet long-term rates are falling:

    The Fed is clearly in a tightening cycle and I don’t think that the market has fully appreciated the real interest rate impact of the Fed reducing its $4.5 Trillion balance sheet. Forget about future Federal Funds rate target increases slated for the balance of 2017, the impact of shrinking of the Fed’s balance sheet alone will remove a significant amount of monetary accommodation from the system. As seen above, long-term treasury yields have been declining which is not unusual as the Fed begins lifting short-term rates. The resulting flattening of the yield curve then is also normal for this phase – and we have seen this in spades recently.

    So where do we go from here? The best outcome in my opinion would be a gradual rise in long-term rates and a steepening of the yield curve as the market discounts higher economic growth rate with just the right amount inflation, and the economy (finally) grows in the absence of ultra-low interest rates. There are two other outcomes which are not so favorable: short-term rates continue to rise and the yield curve becomes inverted which is traditionally a sign of impending recession, or interest rates rise quickly as a response to higher inflation expectations (the less likely of the two in my opinion). Either way, interest rates matter big time.

    Interest Rate Environment Assessment: Above Average Risk of Crisis

    3. Assess the health of the consumer

    One way or another, the effects of economic activity, interest rates, price levels and the cumulative impact of government policy is born by the consumer. As the consumer fares, so (eventually) does the economy. As such, developing a view of the economic health of the consumer is a critical component of crisis spotting. The following are the consumer health indicators in my crisis spotting mechanism:

    Consumers are working:

    The US economy is basically at full employment and will be above full employment (lower unemployment rate) soon in my opinion (think for a minute what this might do to inflation expectations and the future path of interest rates as discussed above).

    Consumers’ income is “ok”:

    Median incomes have been rising, albeit stubbornly, since the Great Recession. As we near full employment, wages should continue to rise, although the pace and duration of such is far from certain.

    Consumers have a lot of debt:

    Consumers have incurred a record amount of debt. Student loans, auto loans and credit card debt have exploded with all three at or near all-time highs while mortgage debt is below the pre-recession peak due to the relative difficulty of obtaining mortgage credit (especially for less-than-prime borrowers).

    But they seem to be servicing it well:

    Delinquencies on consumer loans remain at historically low levels. Delinquencies have begun to rise in the past year with significant increases in subprime auto loans and credit cards but this is not overly worrisome, in my opinion.

    Consumers are historically wealthy:

    Very recently US household net worth climbed to a record $94.8 Trillion. This is largely due to recent stock market gains and the rebound in real estate values which in some areas of the country have surpassed their 2007 peaks.

    Consumer Financial Health Assessment: Below Average Risk of Crisis

    4. Make and update your assessment as to the likelihood of coming crisis

    Finally, synthesize your findings and reach a (temporary) conclusion regarding the current risk of a crisis. Again, we are not talking about pinpoint accuracy but rather a high level assessment of the current conditions. Think about it like those weather forecast graphics you see on TV or your mobile app. You know where it goes from just the sun, to the sun and a few clouds, to a lot of clouds and some rain to the one with the dark clouds, rain, lighting bolts and that guy or gal blowing the wind. Which is it for you?

    For me, my temporary conclusion is that there is currently an above average risk of a crisis (or recession).

    You don’t need exact precision to be an effective crisis spotter. You just need create your own crisis spotting mechanism and continually review and refine your risk hypothesis based on its signals. The goal is to inform your risk taking appetite for your business and personal ventures, not to call the next crisis to the day.

    Happy hunting.