If You Are Early, You Are Wrong

By Joakim Book

There is this fantastic scene in the movie The Big Short that ought to teach everybody about the hazards of prediction in financial markets.

Lawrence Fields and his associate Martin Blaine, large investors in the fund run by the eccentric Dr. Michael Burry, storm into the latter’s office and demand that he stop shorting the housing market. After admitting that the fund pays up-front annual premiums of $80–$90 million — for a fund with $555 million under management — Burry tries to excuse himself by saying, 

Watch! It will pay! I, I may have been early, but I'm not wrong.

To which Blaine desperately cries out,

It's the same thing! It's the same thing, Mike!

Burry, managing the investment fund Scion Asset Management, has made several credit default swap trades with major Wall Street banks. If enough mortgages defaulted, those banks would pay Scion a sizeable amount of money; meanwhile, Scion has to pay monthly premiums. In effect, what Burry bought was a standard insurance policy, but for financial assets. 

In substance Burry was right all along, and the viewer cheers for him; the financial instruments containing non-performing mortgages were vastly overpriced in that they did not accurately reflect the default risk of many homeowners. But he got the timing completely wrong, which meant that he paid out premiums for months and months without seeing the outcome he had so delicately predicted. 

Looking at us from the afterlife, Galileo, Copernicus, Darwin, or Semmelweis, or any other underappreciated scientist whose convictions gained widespread acceptance only after they had endured ridicule and persecution, could legitimately say, “I told you so!” — as could Burry. 

On this point there is a major difference between the natural sciences and economics or finance, a difference that the hedge fund legend George Soros calls reflexivity: in financial markets, how others act impacts the “fundamentals,” the subject matter that forms the basis of all financial assets. While Galileo was always right about how gravitational forces act on different objects, regardless of what other people think on the subject, Burry was vindicated by later events only once they happened. They could have turned out differently — or years later, after which he would already have bankrupted his fund. 

Before a financial meltdown, there is no way to conclusively tell that a financial meltdown is imminent, even though a lot of pundits and cranks try. If there were, reflexivity, the Lucas critique, Goodhart’s law, and the efficient market hypothesis inform us that asset prices would fall today, moving up the financial meltdown in time — and so undermining the very theory on which you based your financial premonitions! 

In economics, contrary to the saying, hindsight is not really 20/20 since the data economists deal in are noisy and thick; past events plausibly support many different interpretations, so the economic verdict of a given event is hardly ever “settled.” That means that we can’t distinguish between a sophisticated forecast that actually happened (a true positive) and a nonsense forecast that accidentally came to be (a false positive) — even in hindsight! The only way to do that, says Philip Tetlock of the University of Pennsylvania, who has long studied predictions, is to track the same forecaster over and over to see if their insights generalize. 

That’s bad news for economic forecasting, but good news for media outlets and hedge fund managers. For some unfathomable reason, we want to read and hear doomsday-sayers and permabears laying out their most scary cases. We have this incredible desire to believe that our professional money managers are in the know. They have superior knowledge both to us and to their industry colleagues. Reliably deciphering the future is hard, if not impossible, and believing otherwise amounts to what our summer intern Sam Frank mockingly wrote about pundits calling for recessions: 

There has been an inverted yield curve in the market approaching three months in length. The high demand for and low yield of long-term debt is a sign that people are preparing for a recession. It has been an indicator of recession in many cases in the past, so of course one must be coming now. Oh, and there is too much complacency in the economy. There is always complacency before a recession, a calm before the storm. Most professional investors believe that a crash is not coming, so of course that means one is on the way. They always hit you by surprise. Except me. I am the one who can predict recessions. Sure, I have been wrong in the past, but this time I am right. Trust me.

It’s been shown again and again that the vast majority of actively managed funds underperform a broad stock market index. Professional money managers, despite their elaborate models and number-crunching information superiority, struggle to mirror the returns of the S&P 500 — and they almost certainly won’t beat it. The few that do can’t keep doing it, which suggests that their individual-year overperformance was due to luck rather than skill. 

This becomes even more important now that the real Michael Burry is throwing out investment advice left and right. When this advice turns out to underperform the general stock market, we know that the laudable and impressive foresight shown in the movie and the book was based on luck — not skill. 

Indeed, we can mention more soothsayers whose financial forecasts are reliable only in their failings. Steve Keen, an Australian macroeconomist, operates complicated models that have predicted a global debt-fueled collapse longer than I have been an adult. The infamous goldbug Peter Schiff has recently received media attention again as the price of gold has moved upward. He reaffirms his $5,000 price target for gold, for which he has been wrong (sorry, “early”) his entire career

Another doomsday forecaster, Jim Rickards, has published numerous books that keep calling for the inevitable (yet strangely not-yet-occuring) collapse of central bank–governed fiat systems — and a $10,000 price tag for gold. Increasingly fanciful claims about how brilliant Bitcoin is have given rise to extraordinary forecasts (here, here, or here) for the dollar price of that cryptocurrency — admittedly accompanied by equally mistaken forecasts by economists and central bankers hostile to Bitcoin.
Worse than all that, as we go through our everyday lives and are exposed to various fanciful predictions of doubtful quality, every single one of those fortune-tellers can invoke what in Michael Burry’s case seemed like a convincing defense: I may be early, but I am not wrong. 

Well, no, Dr. Burry. As much as we appreciate The Big Short and root for your character in the movie, the pesky Martin Blaine makes the most prudent argument. If you are early in financial markets, you are wrong. 

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Joakim Book

Joakim Book holds a masters degree from the University of Oxford and has been a visiting scholar at the American Institute for Economic Research in 2018 and 2019.