Should You Trust Market Crash Forecasts?

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Source: Pixabay.com | Photographer: Geralt

Incredibly low interest rates over the past decade. Surging debts on a global scale. Escalating trade tensions between leading economic powers. Extreme currency volatility.

These are all troublesome signals that immediately raise red flags in everyone’s minds about an impending financial crisis. And rightfully so since, if history has taught us anything, it’s that the markets go through repeated economic cycles of expansions and contractions.

But while most of us can sense that an economic downturn is probably coming, trying to come up with an accurate market downturn prediction can be a real brain-twister. With that said, what makes a market crash so notoriously difficult to predict in spite of all the “obvious” clues?

The element of randomness in a math-driven system

 

To understand where the experts’ painstaking calculations hit a dead end in the hours preceding just about every economic recession, let’s first go over the symptoms that typically precede a stock market crash:

  • Bullish trends that dominate the market for an extended period of time;
  • Prices that are driven to unsustainable highs due to the bullish trends;
  • Excessive debt and leverage as a direct response to the sky-high prices.

Now here’s where things get a bit hazy. The main reason why almost all prediction models concerning global financial crisis miss the mark completely is that they are primarily based on raw data, as is the case with the three signs above. And the trouble with these “fixed” parameters is that they often leave the actual driving force of the markets—that of the erratic human behaviour—out of the equation.

Can you really trust market crash predictions?

 

In times of great economic uncertainty, it’s all but uncommon for investors and traders to crack under the enormous pressure and make irrational choices that lead to extreme market volatility.

What this essentially means is that crisis models that don’t account for the unpredictability of human behaviour are objectively unable to paint a realistic picture of the markets, let alone assess how much time the economies will need to recover from the crash.

However, all of this didn’t stop some analysts from trying to come up with a prediction that takes the randomness of human nature into account. One such analyst is Ray Dalio.

Ray Dalio’s attempt at solving the age-long puzzle

 

In his latest book, entitled A Template For Understanding Debt Crises, the founder of the Bridgewater Associates hedge fund set out to identify certain market patterns by diving deep into the archives of past economic recessions.

And the results did not disappoint. After long and exhausting hours of comparative analysis Dalio found out that:

  1. Prior to each of the several market crashes in the past, interest rates were either kept very low or stayed at 0.
  2. The price of financial assets skyrocketed to the point where there was an almost palpable gap between the well-to-do and impoverished members of society.
  3. The economic relations between leading countries were highly strained, similar to the ongoing feud between present-day China and USA.

Dalio also found the current conditions to be strikingly similar to those in the years preceding the 1937 recession, concluding that we might just be looking at another financial crisis in the next two years.

So, what’s the main takeaway here?

 

As well-researched as Dalio’s predictions may be, there is no guarantee that his forecasts (or anyone else’s predictions, really) will ring true a couple of years down the line.

The reality is that almost all downturn predictions in the global markets’ recorded history have either turned out to be inaccurate at best, or completely misleading at worst. But if you can’t rely on well-researched market data published by highly respected financial experts and you know a market crash is coming, what else can you really do about it?

Two words—plan ahead! Unfortunately, only you can protect your funds when the markets go off the rails. You thus need to have an emergency plan in place to be fully prepared for an economic downturn regardless if Wall Street crashes today, tomorrow, or two years from now.

Coming up with such a plan is no easy feat and will require you to carefully research businesses that are likely to enjoy a sustainable growth at a time when all other financial assets tumble. You would then have to invest in those industries that you follow closely and are knowledgeable about.

Finally, to avoid costly mistakes, you will need to constantly remind yourself of the risks you take for trading at a time when indices are reaching record highs. But regardless of which strategy you ultimately decide to employ, remember to never take economic forecasts at face value lest you want to build your castle on sand.