A Season for Cassandras


The meltdown in the credit markets is sweet vindication for some prognosticators who had been dismissed as merchants of gloom

For 16 years, Stephen Roach served as chief economist at Morgan Stanley (MS) and proved to be one of the gloomiest voices on Wall Street. Take for example his July, 2005, critique of incoming Federal Reserve chairman, Ben Bernanke. Roach wrote of "the mounting pitfalls of yet another post-bubble shakeout—this one dominated by the downside of overvalued property markets and the concomitant unwinding of a potentially lethal debt cycle."

But for years, no shakeout came. Stocks continued to surge. In April, Morgan Stanley moved Roach off the highly public economics beat, after few of his predicted calamities came to pass, and assigned him to drum up business behind the scenes as chairman of Asian operations. Only a few months later, however, the bond market turmoil is following just the path that Roach once predicted.

"Perma-Bears" Savor the Moment

Amid falling home prices, crashing hedge funds, and panic selling of all kinds of securities, Roach finds himself in a tiny but elite group of analysts who saw such problems on the horizon but were widely ignored by investors. Derided as "perma-bears" by some, the group includes money managers John Hussman and Nassim Nicholas Taleb, economists Nouriel Roubini and Paul Kasriel, and authors Jim Grant and Richard Bookstaber. Now they have a moment to savor, even as most of their peers struggle with the growing crisis. (See Catching Up With Bond Market Doom Seers)

Peter Bernstein, author of the award-winning financial history Against the Gods: The Remarkable Story of Risk, says it's the same story in almost every market cycle. Like Cassandra, the figure from Greek mythology whose predictions were always correct but never believed, a minority of analysts often warn about the growing dangers, says Bernstein, who has worked in and around the capital markets since 1951. "I cannot recall a period without them, and I have been among them in my time," he says, adding that the past few years showed all the classic signs of "irrational exuberance" that was "doomed to come to a bad end."

Author Richard Bookstaber, who worked on Wall Street and for several hedge funds as a risk manager, says he feels lucky that his book warning of problems with leveraged investment strategies and derivatives hit the shelves this year. Calling the current problems "inevitable" given the market environment, Bookstaber says he's also relieved. "The longer we kept going on the course of higher leverage and complex derivatives, the worse the end result would have been," he says.

Detractors Remain Unswayed

Not everyone is convinced that the Cassandra crowd deserves applause. Money manager and blogger David Merkel says that while the gloomy analysts may look good in the short term, there's no money to be made by following their advice over long periods. A diversified portfolio will more than make up for the losses of the occasional bear market, he argues: "Over the long run, absent war on your home soil, depression, or rampant socialism, the markets favor the bulls.… For most investors that means sticking with their discipline through good times and bad and not getting greedy or fearful."

Hedge fund manager Nassim Nicholas Taleb does no such thing. After a few years on the sidelines, he helped launch a new $300 million fund to profit from most investors' cavalier disregard for extreme market moves. His most recent book, The Black Swan: The Impact of the Highly Improbable, should have been required reading at all of the quantitative hedge funds using computer models to eke out small profits from thousands of trades and magnifying their returns with borrowed money. Funds run by Goldman Sachs (GS), Barclays Global Investors (BCS), Sowood Capital, and legions of others might have avoided billions of dollars in losses if they'd better anticipated unlikely market conditions. Taleb dismisses much of the so-called quant style as "picking up nickels in front of steamrollers."

Newsletter author Jim Grant admits that in prior downturns, he spent a little too much time basking in the glow of vindication. After spending the last few years warning about the dangers of securities backed by subprime mortgages, he's now trying to find opportunities for investors. A recent article reviewed the prospects of Countrywide Financial (CFC), concluding that it was still too soon to buy the company's stock. "For the past few months, we've been looking at the markets from the position of a would-be salvage buyer," Grant says. "I have resolved that I will not be the most bearish person at the bottom."

As for Taleb, he's been on vacation for much of the summer and didn't return an e-mail seeking comment. In an Aug. 16 post on his blog, Taleb took a tongue-in-cheek swing at his many critics. "I am at the Edinburgh literary festival and the last thing I care about is you finance people," he wrote. "I've been swamped by e-mails telling me that I was right.… I don't understand these e-mails. It is as if I didn't know that I was right. Tell me what I don't know."

Pressman is a correspondent in BusinessWeek's Boston bureau.

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