Proof That Stock Market Crashes Aren't Predictable

If predicting what the stock market will do next is easy, then everyone would be rich. This is nothing short of a near-universal truism in modern finance theory. As my colleague Morgan Housel put it: "The single most powerful variable when trying to predict the future is the 'X' factor that represents human psychology, historical unknowns, and random chance. It doesn't care about your political views or what you think is a fair market value, and it's going to humiliate your predictions 90% of the time."

Nonetheless, many people continue to believe that they can outsmart the market, that they are the exception to this rule. At a recent gathering among friends and acquaintances, I overheard a young man talking about how he's making a killing trading options. For the record, the gender here is highly relevant, as most women (and Warren Buffett) are far too sensible to trade options.

Was he using them to hedge? No. Did he know how to value them? No. He was simply buying and selling calls and puts -- that is, the right to respectively buy or sell a specific stock at a certain price within a predetermined time period -- as you would a stock. When I heard this, all I could think was that he's either crazy, stupid, or in desperate need of a loss to offset investment income elsewhere.

Two weeks later, I was at the gym (which is a pathetic sight, to be certain) and happened to listen in on a nearly identical discussion. I say "nearly identical" because this guy was bragging about his genius for trading currencies. When a fawning admirer asked what his favorite currency to trade was, he said the Australian dollar, because it's "the cheapest."

Now, while I admittedly know little about trading currencies, I do know that the price doesn't matter. It's the same thing as saying that you like to trade Bank of America stock as opposed to, say, JPMorgan Chase's because the former is less expensive. Just to be clear, what matters is the percentage increase, not the price. The point being, this guy had no idea what he was talking about but had nevertheless deluded himself into thinking that he did.

To be fair, I think everybody who invests goes through this overconfident stage at some point early on. I'll be the first to admit that I, too, once harbored beliefs like these. But years of investing and a few classes in the school of hard knocks, if you will, have taught me otherwise. Virtually every time I tried to beat the market by attempting to foreshadow a move, and many times using options, I lost.

But to say that someone can't predict the market and to prove it quantitatively are two separate things. And it's for this reason that I found the following chart so insightful. The data for it comes courtesy of the Yale School of Management's Crash Confidence Index, which measures investor confidence that "there will be no stock market crash in the succeeding six months." I then contrast this with the monthly level of the S&P 500 .

If you're relatively familiar with what's happened over the past few years (and the timing of events in particular), then the chart is probably self-explanatory. But if not, then there are two things I want to point out.

The first is the spike in crash confidence that occurred in July 2006 -- and remember, the higher the number, the higher the confidence that the market won't crash. While the market didn't crash until the following year, it was during this precise time period that the credit markets started to buckle under the weight of the subprime lending crisis. And it was this buckling that ultimately caused the stock market to later implode.

The second is the nadir of confidence in March 2009 -- and again, this suggests that investors were predicting a crash. That is precisely when the S&P 500 began its upward ascent. In other words, investors were wrong on both counts. They were confident that it wouldn't crash on the eve of its doing so. And they were confident that it would crash just as it began the ongoing bull market in which it's since more than doubled in value.

This is an important lesson. We can't predict what the market's going to do. We can only identify good companies trading for good values today. In short, don't be that guy at the gym or the party who's naively overconfident. To anybody who knows what you're talking about, it's neither cool nor convincing.

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