Explaining 2014’s Mythical Market Meltdown

U.S. stocks and bonds both gained in 2014, while the price of oil plunged, just like a whole lot of nobody predicted. But I’m going to take you to an alternate reality and write some commentary that the media would be delivering if markets had plunged. I’ll wrap up with some commentary on how market commentary can be so dangerous.

News Release 4:01 PM ET 12/31/14

Markets gave a collective sigh of relief that the carnage of 2014 was finally over. The Dow Jones industrial average plunged another 352 points on the last day of the year, ending down 35.2 percent for the year.

Most of the stock plunge was obvious and easily predictable, as valuations hit unsustainable levels. Nobel Economist Robert Shiller pointed out that his CAPE (cyclically adjusted price earnings) index had reached unsustainable levels only exceeded in 1929, 1999 and 2007. Stocks were destined to fall, and it’s likely the 2014 plunge is not even half of the further losses we predict the coming year will bring.

Besides valuations being out of whack, the world has been thrown into a turmoil never before seen. The rise of ISIS in the Middle East has turned the region into a free-for-all, while Russia has returned to its Cold War approach of annexing neighboring countries.

North Korea’s hacking of Sony’s entire IT structure revealed a whole new form of combat—cyberwarfare. Many believe it’s only a matter of time before cyberterrorists shut down the world’s financial system. This is indeed a new paradigm.

Bonds also plunged as interest rates soared, and there was nowhere to hide. Experts agree that this was a result of the U.S. government following through with its promise to end quantitative easing. That, too, was predictable to a degree, since 44 of the 45 economists surveyed by the Wall Street Journal predicted the 10-year Treasury bond yield would soar.

Still, none predicted the 10-year rate would rise to 5.73 percent, as the impact of ISIS wasn’t yet known. This, of course, directly led to $208 a barrel of oil and gas prices averaging $5.44 a gallon. The current stagflation environment is even fiercer than we saw in 1980.

What will 2015 bring? A survey of 73 analysts predicts there will be more of the same, with some predicting the Dow will hit 3,000. Only Harry Dent, in his book, “The Great Depression Ahead,” made such a prediction in time to actually help investors. Investors are pulling billions of dollars daily out of ETFs and mutual funds as money market funds are seen as the only safe haven.

Only one thing is clear for 2015: Cash is king and is the only place to invest in 2015, at least until this never-before-seen risky world hopefully becomes a bit less risky. That, of course, is very unlikely.

Commentary Of My Imaginary 2014

Not everything above was fake. Professor Shiller really did make that comment on valuations (though he stated it didn’t necessarily mean a coming crash) and economists did uniformly predict rate increases in 2014, continuing a long track record of being directionally wrong most of the time.

And though their impact on the world didn’t reach my imaginary “Code Red” scenario, the threats presented by ISIS, Russia and North Korea are all too real. In reality, U.S. stocks and bonds performed quite nicely while oil plunged, and there is no shortage of market commentary explaining why markets did what they did last year.

The point is that it’s quite easy to come up with market commentary explaining why markets do what they do over any year, month, day or even each moment. Easy, but totally made-up nonsense, just like my plausible explanation of exactly the opposite of what actually happened in 2014.

Curiously, that nonsense makes us feel better. We think we understand markets and feel more in control of what will happen in the future, even though that predicted future is nearly always an extrapolation of the recent past. This addiction to prediction causes us to repeat the pattern of buying high and selling low.

In truth, markets are complex mechanisms. We can’t even explain the past when it comes to market movements, and the market continues to make fools of those who think they know the future. Even investing based on sound economic analysis fails us.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for CBS MoneyWatch.