Why Recessions Are So Hard To Predict with Morgan Housel [LIVE] (EP.125)

Well, I mean, the first was you have to keep your expectations in check and realize that that's probably going to be the peak of it and probably not something that you could follow up. So, I've been a financial writer for my whole career, and it was apparent early on, and this will not be a surprise to many in the room, how bad the industry was at forecasting the next bear market, the next recession, whatever it was. The track record is pretty abysmal for the whole industry, fund managers, economists, whatever it is. And so, there's two things you could do with that insight, with that realization. You can kind of become a cynic and just say, 'Nobody knows anything.' Or you could say, 'Well, what do we know is not going to change? We really have no ability to predict the change, the big change, particularly the events like COVID or 9/11 that move the needle so much. Nobody can predict those things. So, let's put all of our emphasis on what we know is not going to change.' That was kind of the first part of it.

The second part that really got me interested in this is my favorite finance book that's ever been written is a book called The Great Depression: A Diary. And it was a diary that a lawyer named Benjamin Roth kept during the Great Depression in the 1930s. He was a bankruptcy attorney in Youngstown, Ohio. And he just kept a very detailed diary about what he was seeing going on during the depression. And his son published it in 2010. And there was a point in this diary in 1932, which was the bottom of the depression, where Benjamin Roth writes, 'If you change the dates from 1932 to 1894, everything aligns. What happened in 1932 is exactly what happened in 1893, and it's exactly what happened in 1875. All the other depressions, it was the same story, exactly the same.' And then reading a couple pages later, it occurred to me that if you change the dates from 1932 to 2008, it would seem like it would fit right in.

So, it's just an observation that like the details change, the actors change, but it's the same movie over and over and over again. And not just for like big depressions, but I think it's true for bear markets, like all financial cycles. There's so much to learn, not the technical details of what happened, but just the behaviors that took place have not changed for hundreds of years. So, let's put all of our emphasis in that rather than pretending that we can predict the big changes of what is going to cause the next bear market or the next recession. That's really where it came from.

I think for one, it's exciting to predict the change. If you can do it right, it's extremely lucrative. If you know exactly what the next industry, what the next company's going to be, that's of course a very lucrative endeavor. So, we're always going to be drawn to that. I also think there's a sense of if you admit to yourself that we don't know what's going to happen next in terms of the specific changes, that discomfort of uncertainty is really hard to deal with. And the idea that we can predict it removes that uncertainty in a way that feels great. And I do think that a lot of the prediction in the financial industry is implicitly at least designed to reduce that uncertainty that's so uncomfortable for people. So even if the track record is what it is, it's never going to go away. Both because it can be so rewarding for the few who can do it right and because the opposite of it, the admitting that we don't exactly know, is so painful.

And one really important point here too is that the financial industry, and this is true for many different fields, politics, medicine, all kinds of things, is actually very good at predicting the future except for the surprises, which tend to be all that matter. Because what moved the needle more than anything in the past 25 years in the economy, 9/11, Lehman Brothers, and COVID, by an order of magnitude, those were the three events that just completely changed the world. And the common denominator of all three of them is that nobody saw them coming, particularly 9/11 and COVID, not in any economic outlook, no analyst forecast, and moved the needle more than everything else that came before it. So it's not that we don't have any ability to track the economy. It's just that once a decade there is an event that was impossible to predict that completely and utterly changes what's going on in the world.

I think this is where a lot of history comes into play because beyond 9/11, Lehman, and COVID, you could also throw in Pearl Harbor, of course, a lot of the political developments of shutting the gold window off in the 1970s. Like the really big mega-economic events were things that just by their nature you could not see coming. And so that's the biggest lesson from economic history is that risk is what is left over when you think you've thought of everything. So, it's good. It's a great thing to do to analyze all of the risks in front of you and try to come up with a probabilistic analysis of how they're going to impact you. That's a great thing to do at the individual level, too. What are my individual personal financial risks in front of us? Great. But then you have to accept that after you're done with that exercise, the biggest risk is what's not on that paper. And it's always been like that.

And you can state with certainty that the biggest economic event of the next 12 months and the next 5 years, the next 10 years is something that nobody in this room or this entire industry is thinking about because it's always been like that. I don't think there's ever been a single 5-year period in which the biggest risk in hindsight was foreseeable. One of my favorite examples of this is The Economist magazine, which is such a great publication. I think it's the most astute financial journalism that exists. Every January they publish an edition that is a preview of the 12 months ahead. Here are the global economic risks for the 12 months in front of us. They've done this for a hundred years every January. Their edition in January of 2020 does not say a single word about COVID, which of course nobody was talking about when they wrote it in December 2019. Nobody could have known. And their edition in January of 2022 does not say a single word about Russia, Ukraine, or oil prices, which again, of course. And then of course if we're looking at this year, Hamas and Ukraine and whatnot, like the things that are actually a big needle-moving event with the most astute financial journalists in the world in hindsight are never in there. And that's not a criticism of them because they're very smart people. It's just to highlight that these things that we can't see coming are the things that matter the most.

And when you have something as quantifiable as investing and you can look at a statement every quarter and say, 'Of course this was going to happen.' A really common example that I feel like I run into with people is, 'Of course interest rates were going to go up and bond prices were going to fall.' But if you look at the dot plots that the Federal Reserve published, they didn't even know they were going to raise rates the way that they had to.

I started thinking about this a couple years ago when I was watching an interview with David McCullough, who is one of the great historians of our time. I think he passed away not too long ago, but one of his many books was about the Revolutionary War. And there's a scene, there's a point in the Battle of Long Island during the Revolutionary War where George Washington and his troops were cornered by the British. And all the British had to do was sail up the East River and they would have cornered George Washington and it all would have been over. But it didn't happen because the winds were blowing in the wrong direction that night. So the British could not sail up the East River and George Washington and his troops got away, regrouped, and then the rest was history.

So David McCullough is being interviewed by Charlie Rose and Charlie Rose says, 'If the winds were blowing in the right direction that night, would the British have won?' And David McCullough said, 'Absolutely.' And then Charlie Rose says, 'No United States of America in that scenario?' And he says, 'I don't think so.' So literally just the existence of this country relied on the winds blowing in the right direction in Long Island during this one night in the 1700s. And I think there's so many examples of that in history where this tiny little nothing event that nobody thinks anything about utterly changes the path of history.

A week or two before he was sworn into office, FDR was almost assassinated. There was an assassination attempt. The mayor of Chicago was standing next to him and actually took the bullet and he died. And so here's another alternative history. If the bullet was six inches in the other direction, probably no New Deal, which still has a major impact on the economy today. You could list dozens of these things of if one little tiny variable went a millimeter in the other direction, everything completely changes. And I think when you immerse yourself in those kind of stories, it humbles you in your ability to try to predict what's going to happen over the next 10 or 20 years. When you realize how ridiculously fragile not just the economy, but the entire world is.

I mean, nothing is more persuasive to you than what you've experienced firsthand. And since everyone has experienced a millionth of a percent of what's happened in the world, every one of us, myself, everybody is blind to a lot of how the world works and what is possible and how other people think. And so, yeah, it's a major point. One of the criticisms that I thought was a valid criticism of The Psychology of Money was it's written through the lens of a college-educated white American male. And my response to that was like, valid criticism, but of course, because that's what I am. Everyone is seeing the world through the lens of their personal experiences.

And you see this a lot with, it's been very well studied and documented, the generation who grew up during the Great Depression. How that scarred them for the rest of their life and relative to the generation before or after them. If you were particularly a young adult during the Great Depression, that stayed with you forever. And your willingness to take risk, your willingness to avoid debt, it stayed with them forever. So everybody wants to think that you are analyzing the world objectively and you're just looking at the data and it's telling you what to do. But all of us view that world through the lens of our own experiences.

One of the ways I saw this last decade was after the financial crisis of '08 when the Fed was printing a lot of money, gold became very popular for a period of time. And there were a couple studies that came out that showed what generation was gold popular with almost exclusively. And it was not our generation. It was the baby boomers who came of age in the '70s and '80s and remember 15% inflation, remember 16% mortgages, which our generation, we could read about it, we could try to empathize, but if you don't have the scar tissue of dealing with that in the '70s, even if we're looking at the same data, it's totally different.

The other thing I've always thought was interesting is that until COVID, Australia went 27 years without a recession, a full generation with no recession because they had so much demand from China for all the rocks in the ground that they were digging up. And so if you went to Australia before COVID, if you went there in 2019, they viewed recessions as like a theoretical risk. They knew it could happen, but almost nobody, even the grizzled veterans, had never actually experienced it. And you compare that to America where we've had three or four recessions, two of which were really bad. Completely different view. Even if we're just as smart as one another, we have the same data, the same academics, etc., totally different view on how economies work.

One other story about this. This is probably a decade ago now. I did an interview with Daniel Kahneman, the psychologist who won the Nobel Prize in economics, and he started talking about that idea, how what we've experienced in our own life impacts what we believe about the world. And then later in the interview, he said at one point that he's the biggest pessimist that he's ever met in life. He said, 'Nobody is more pessimistic on like just the outlook of humanity than he is.' And we said, 'Wow, that's really interesting. Is that because you have all of this insight into how our behavior goes astray?' And he said no. He said something to the effect of, 'I'm a pessimist because I grew up in Nazi-occupied France and I saw from an early age how evil people could be.' And of course that's not an experience that I had. But that was what he grew up with, the emotional and mental scars of that that lasted through today. He's in his 80s now.

So everyone has some version of that, of an experience, a really good experience, a really bad experience, that we think we're viewing the world objectively. But when you actually talk to other people who have had different experiences, we're all just viewing it through our own lens.

I mean, here's one example of that. The CPI index is an index of kind of like average spending. They weight it by how the average household spends their money. Okay, the average household spends 17% of their income on groceries, whatever the number is. I'm making that up. And that's how they weight it. Well, by definition then that weighted average applies to nobody. Nobody is average. It's the right way to do it. But this is why I think there's a big subset of the population who thinks the CPI is a scam because it doesn't map perfectly to their household spending.

And these numbers might be a little bit off, but I think it's roughly a third or a quarter of US homeowners own their house outright. No mortgage. Well, what percentage of CPI is housing prices? 25%, in that range. So for a quarter of Americans, a quarter of CPI doesn't even apply to them. It's something that they're not even spending their money on. And so if you take somebody who is in college and commutes a lot and has a gas guzzler and compare that to someone who is retired and drives a thousand miles a year, everyone has their own individual inflation rate. And that's why your own experiences can be so different from other people, but most people when they view the CPI and it says it's 4.5%, but they know that their prices are up 10% in the past year, the knee-jerk reaction is the CPI is wrong. It's a scam. They're manipulating the data when it's actually just an indication of how everyone spends their money differently.

Well, you said something interesting that social media gives you what you want. A little nuance, I would say. It gives you what you're going to react to, which is like a little bit different. And a lot of times what you're going to react to is not necessarily what you want. It's just what's going to get your attention. And that's a big thing with social media. But also in news, like a big change in the last half century is that news went from local to national to global. And it used to be that every small town had three newspapers and it was local news. And yes, you heard about the national stories, but most of what you cared about was the news in Detroit, the news in New York. It was all local.

Once that spread and went to national news and then kind of the global CNN, Fox News, where it's talking about everything. If you're in your individual town, what are the odds that someone is going to be, let's say, murdered today in a small town? Very low. Maybe it's one a year or something like that and you'll hear about it then. What are the odds that someone is going to be murdered in the country today? 100%. And what are the odds that there's going to be a really, really out-of-the-blue one-in-a-million event in the world today? Also 100%. So once the news spreads to a larger audience and the news that's going to catch your attention is the bad stuff, well then you're always going to be flipping on the news and hearing about the terrible things because local news talks about the high school football games, but the national news and the world news talks about the terrorism attacks. So once the news spreads to a broader level, even if the world is by and large safer today than it was 50 years ago, the news I think can seem much more negative than it was just because that's what's catching your attention and it's just a much larger sample size to draw from. So I think that plays a big part.

The other thing about social media though, that like a really good algorithmically curated Instagram feed or Facebook feed has been around for like 5 or 10 years, not that long. So I don't think we fully understand what it does to people's psyches and mindsets. A really interesting thing, and this is a CFA group, so I can kind of go into detail here, the correlation between consumer confidence and an index of economic variables, GDP growth, that kind of thing, was fairly correlated for a very long period of time. And in the last two years, it's just deviated by an incredible amount. Consumer confidence today relative to really good unemployment, pretty good GDP growth, stock market doing pretty well, it's deviated today like never before. And I wonder if at least part of that is because even if the economic variables are pretty good today, it's so easy to scroll through your social media and think the world's going to hell. I think that's at least part of it.

And it's a pretty new phenomenon that we don't, I mean, I can't imagine what 2008 would have been like if we had Twitter. I think it technically existed back then, but nobody was on it. It would have been completely different. And in a world where back in the '90s, not that long ago, everybody got their evening news from Tom Brokaw. Everyone's the same. And now it's pick your poison. Whatever you want to hear, that's out there. It's such a new thing that I don't think we know what the ramifications of it are.

Yeah. And it's a great point. I think in general being an optimist doesn't mean that you are saying everything is sunshine roses. You can acknowledge bad things will happen.

Yeah. It's like it's a big barbell. I always refer to it as save your money like a pessimist and invest your money like an optimist. Save with the idea that the next 12, 24 months, five years are going to be tough because they usually are. It's usually a never-ending chain of surprises. But invest your money with the idea that if you can endure that and make your way through, the rewards for investors who can stick around can be great. That seems pretty simple, but I think for a lot of people, getting optimism and pessimism to coexist is difficult. To have that barbell personality is pretty difficult. My favorite example of this is Bill Gates who back in the 1970s when he started Microsoft took the most optimistic swing at the bat that any entrepreneur has ever taken where in the 70s he said every desk in the world needs a computer on it which seemed completely insane back in the 70s. Very optimistic. On the other hand, he managed Microsoft from day one so that they would always have enough cash in the bank to make payroll for one year with no revenue. And through his tenure at Microsoft through the early 2000s, he kept that promise. He always wanted to be able to run the company for 12 months with no revenue, which is the most pessimistic way you can run any company. So crazy optimistic on one hand and very pessimistic and conservative on the other. And I think that's at least a part of why Microsoft has done so well. It's like they've gotten optimism and pessimism to coexist. The other story that I like here is Mike Moritz from Sequoia, the most successful VC firm that's ever existed. He was doing an interview with Charlie Rose as well and Charlie Rose says, 'You've been the dominant VC firm for 40 years. How have you done it? What's your secret?' And I loved his answer. He said, 'We've always been scared of going out of business.' And this is a guy who if anyone in the industry has the right to say the reason we're successful is because we're so smart. Now, he didn't say that. He said, 'We're scared of going out of business.' It's such a rare mindset that you can be that successful, that optimistic in seed-stage venture capital and still terrified at the same time. It's a very rare mindset, but I think the people who've done well for a long period of time, who've actually gotten their money to compound for a significant period of time, you need both of those like optimism and survival to coexist at the same time and everybody to buy into your story.

Well, I think it's especially important in finance where you know finance is a very analytical field, numbers and data and formulas, and it's great, that's very important, but it's always the case that not even just in the short term but also in the medium and long run, the best story wins. Not the best idea, not the right idea, not the right answer, the best story wins. And of course, you know, there's a Ben Graham quote that in the short term the market is a voting machine. In the long term, it's a weighing machine. But even in the weighing time frame where you're looking at more the analytical side, there's always a narrative component to investing that is so powerful. And one way to think about this is that every market valuation for the market or an individual stock is a number from today multiplied by a story about tomorrow. That's what every valuation is. A number from today like 12-month earnings. And then you multiply it with a story about tomorrow of what you think growth is going to be or what you think the risks are going to be. And the story component is so much more powerful than the current year component, than the number from today. It's always way more powerful. So I think that just keeping that in mind because there are periods like in 2021, 2022 where it seems so crazy and if you are the kind of person who thinks the right answer wins, those are the periods where you just shake your head kind of in disgust wondering what's going on. When you realize how powerful stories are to markets, then it makes a little bit more sense of why people would do these. There's another great story here from Howard Marks who back in the negative interest rate days, he was wiring money to I think a bank in Spain and he wired money and his lawyer said, 'Oh, you don't want to keep your money in the bank because it's a negative interest rate. You're going to have less money by Monday than you have today.' And Howard Marks says, 'Okay, so don't put the money in the bank.' And the lawyer said, 'Well, you have to keep your money in the bank.' And Howard said, 'Okay, well then keep the money in the bank.' So, like when we're looking at why do negative interest rates exist? Why are people putting their money into something where they're going to lose it? There's always just like a narrative side to it. There's a story about it where you're like, 'Okay, maybe it does make a little bit more sense than I thought.'