Lessons from WWI about “markets” ability to see the future

Summary: Brad Delong (Prof Economics, Berkeley) reminds us that on this day in 1914 the NYSE ended the longest period of stopped trading. The outbreak of war on 31 July triggered “the longest circuit breaker” in NYSE history. His post, as usual, gives an interesting account of that episode. Who closed the NYSE, and why? There is another lesson from this history, one of importance to us today.  (This is the second of 2 posts today)

Expect the unexpected: fish

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“Unless you expect the unexpected you will never find truth, for it is difficult to discover.”

— Heraclitus, the pre-Socratic “Weeping Philosopher” of Ionia

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Stock market strategists and economists often tell us about markets’ fantastic predictive ability (an emergent phenomenon from millions of investors), often to the extent of referring to stock prices as a barometer of economic health. Count me among the skeptics when it comes to forecasting.

Here’s a survey of risks by Nial Ferguson (Prof History, Harvard), typical of those before the 2008 crash. He doesn’t even mention the structural weakness of banks, the factor converting a real estate downturn into a global crash. But then nobody saw this (that I’ve found).

Even in what investors should see best — economic cycles — their record is mixed. Sometimes the market gets it wrong; the October 1987 crash predicted nothing. Sometimes the market sees things a little late: the Great Depression began as the US economic downturn began in August 1929; the stock market crashed on October 29 (timeline here).  Sometimes the market gets it right: the stock market peaked on 9 October 2007, the recession began in December, the economy crashed in Fall 2008 (timeline here).

Geopolitics have an immense effect on markets. Here economists have very poor record of forecasting, although they often see themselves as bookies of geopolitics (they tend to be hawks, which is odd given the horrific history of war’s effects). Likewise, investors poorly assess geopolitical threats. On this 100th anniversary of WWI let’s see how well investors anticipated that climatic event (timeline here).

In hindsight WWI looks almost inevitable. Historians see its origin in two decades of rising geopolitical tensions among the major western powers as William Lind explains. Yet investors back then didn’t feel rising tension. For a scholarly yet readable account I recommend Nial Ferguson’s “Earning from History? Financial Markets and the Approach of World Wars” (Brookings, Spring 2008), which provides the quotes below. An assassin killed the Archduke Franz Ferdinand of Austria on June 28. In the following month stock prices declined throughout the western world. Prices of US railroad and industrial shares dropped 15%. The Vienna stock market crashed on  July 13.

Although selling spread of stocks and intensified, investors in most assets in the so-far unaffected nations remained calm (the bond markets dwarf stocks in size). Similar crisis had been resolved through diplomacy. Europe had not experienced widespread war for a century.  Compelling analysis by experts such as Jan Gotlib Bloch (Is War Now Impossible?) and Norman Angell (The Great Illusion) proved war to be irrational and hence unlikely.

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Whirlpool

Apart from an upward movement in Austrian bond yields, there were no significant shifts on either the bond market, the money market, or the foreign exchange markets until the final week before war broke out.

On Friday, July 28, Austria declared war on Serbia and Russia mobilized its army.

… The Vienna market was the first to close, on July 27. By July 30 all the Continental European exchanges had shut their doors. The next day London and New York felt compelled to do the same. Although a belated settlement day went ahead smoothly on November 18, the London Stock Exchange did not reopen until January 4, 1915. Nothing like this had happened since its founding in 1773. The New York market reopened for limited trading (bonds for cash only) on November 28, and something like normal service resumed the following month, but wholly unrestricted trading did not resume until April 1, 1915.

Nor were stock exchanges the only markets to close in the crisis. Most U.S. commodity markets had to suspend trading, as did most European foreign exchange markets. The London Royal Exchange, for example, remained closed until September 17. It seems likely that had the markets not closed, the collapse in prices would have been as extreme as in 1929, if not worse.

No market mechanisms can withstand far more sellers than buyers. Since 1987 the US stock exchanges have relied on trading capacity (ready to handle enough trades to liquidate the nation overnight) and circuit breakers to withstand the next big one. Both will fail, eventually. I suspect they have not given ten minutes thought as to that scenario. As for the rest of us, I believe this describes us today:

The stakes for investors had thus been very high in the summer of 1914, although few of them seem to have known it before the storm broke. The impact of the war was very far from uniform on the various asset classes open to a typical capitalist of the prewar years. John Maynard Keynes’s archetypal prewar rentier, sipping his tea and playing the global markets from the comfort of his London boudoir, had little suspected what havoc would be wrought by “the projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion.” {quote from Keynes, 1919} These forces were indeed the serpent in the paradise of pre-1914 globalization.

Conclusions

The vast majority of research, geopolitical or economic — especially for a general audience — consists of forecasting that the past will repeat. That’s the easy message; that’s what people worry about and hence what sells. People fear the immediate past — a war in Europe (for generations we feared the Soviet armies would storm across the Rhine, something they had little capacity to do), another crash of stock or real estate prices, the great depression or great inflation (1965-1983). Or reappearance of dragons from our past (overpopulation creating famines).

Forecasting new things requires more thought, and has a smaller audience. It doesn’t pay well, and smart people tend to avoid it. Unfortunately, our rapidly changing world, with unprecedented innovations arriving like trolleys, means that we should expect new problems. Rather than the futile guessing about shockwaves (low probability, high impact events), let’s instead focus on resilience. Prepare for occurrence of historically rare but certain to repeat events (is your investment portfolio an “all weather” one?). Before worrying about what the weather might be in 2050 or 2100, have we prepared to withstand the great storms of the past 2 centuries? (the answer is NO.)

Not only will this work well for you, it will save a lot of time.

One more lesson from August 1914: don’t listen to people advocating starting wars. No matter that they say it will be short and cheap. They’re often wrong. Sometimes disastrously wrong.

Don’t you spend a lot of time making forecasts?

Yes, it’s my business. I’m quite good at it. On the top menu bar are buttons to pages listing my hits and my misses. That’s because I’m careful, making forecasts only when the information and logic make a strong case. Even with a high (but realistically modest) batting average, the demand is low. As most analysts will tell you (e.g., the CIA analysts writing about Saddam’s nukes and links with al Qaeda), people with authority want to be told what they already believe.

Key to bright future

For More Information

(a)  Other works by Nial Ferguson on this subject:

  1. The Paradox of Diminishing Risk(Perception) in a Dangerous World“, Drobny Global Monitor, 5 July 2005
  2. Political risk and the international bond market between the 1848 revolution and the outbreak of the First World War“, Economic History Review, February 2006

(b)  Other posts about forecasts:

  1. Is Europe primed for chaos, as it was in July 1914?, 7 October 2011 — Bleak forecasts, wrong for Europe (although Greece was in fact screwed)
  2. Preparing for the future: should we be precautionary or proactionary?, 22 August 2013
  3. Do we face a future without confidence in experts?, 25 September 2013
  4. See the trends shaping our future. Be forewarned, so you can prepare., 11 July 2014
  5. Did anyone predict the 2008 crash? Will anyone predict the next crash?, 12 November 2014

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3 thoughts on “Lessons from WWI about “markets” ability to see the future

  1. Note sent by a reader about the limits of crowdsouced forecasts
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    All wars begin with crowdsouced forecasts of the result. Major wars tend to start with crowds on both sides expecting victory. Usually one side is wrong. Often both are wrong.

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