What’s the Best “Austrian” Indicator to Predict a Crash?

My new book, “A Viennese Waltz Down Wall Street: Austrian Economics for Investors” will be coming out this summer (just in time for FreedomFest in July). It will be published by Laissez Faire Books. In this book, I discuss the various methods devised by Austrian financial experts — followers of the Austrian school of Mises and Hayek — to determine the tops and bottoms of markets. It is not an easy task, and Austrians have been famous for being early in their predictions of a stock market crash. Ludwig von Mises started predicting a crash in 1926, four years before October 1929, and thus missed out on a huge bull market.

Can modern-day Austrians use advanced financial techniques to more accurately predict a crash?

U.K. financial consultant Thomas Aubrey has devised a method in his great new book, “Profiting from Monetary Policy: Investing through the Business Cycle,” published in 2013 by Palgrave Macmillan. I found out about it in a review in The Economist.

In his book, Aubrey focuses on the credit cycle as a way of determining whether to be bullish or bearish. He depends on Swedish economist Knut Wicksell’s natural rate of interest hypothesis and the Austrian theory of the business cycle, where credit expansion and interest rates drive the business cycle and the stock and bond markets. He cites Hayek quite a bit, as well as Wicksell. It appears to be the first book-length effort to apply Austrian/Swedish finance theory.

According to the Austrian/Swedish theory of the business cycle, when the central bank (Fed) lowers interest rates below the “natural” rate, it creates an artificial boom and asset bubbles that cannot last. Market interest rates inevitably will rise and choke off the boom, causing a crash, recession and bear market.

Aubrey uses the return on corporate investment capital (both debt and equity) to represent the “natural” rate of interest), and the five-year moving average of five-year government-bond yields for the “market” rate of interest.

Using these two figures, Aubrey created a number he dubs “the Wicksellian Differential” (WD). When WD widens, Aubrey is bullish; when WD narrows, he’s bearish. Historically, he found that using this model between 1986 and 2011, switching into equities when WD rises, and into government bonds when WD falls, his portfolio earned an 8.7% average real return on U.S. stocks during this 25-year period to achieve an above-average return.

His WD model was especially useful in getting out of the market near the top in 2007. He missed the entire collapse. His portfolio actually made money by investing fully in government bonds. However, Aubrey’s technique was less useful during the tech boom bust cycle in 1996-2001. According to his model, WD started to decline in 1996, just as Alan Greenspan warned of an “irrational exuberance” on Wall Street. He switched from stocks to bonds prematurely, as the Nasdaq doubled and then doubled again. Then he got back in late 1999, only to get hit by the dot-com crash in 2000.

I prefer using the “inverted” yield curve as a way to get out near the top. The Fed raised short-term rates sharply in 1999 and in 2007. Both worked well to get us out of the stock market near the top. Aubrey has tested the inverted yield curve strategy and found that it gave a slightly better overall return than his WD technique, but with greater volatility.

You Blew it! The Fault Isn’t the Teachers, It’s the System

“The interjection of competition would do much to promote a healthy variety of schools.” — Milton and Rose Friedman

On Monday evening, at the Alexander Hamilton Dinner in New York (sponsored by the Manhattan Institute), my wife and I sat next to John Stossel (see photo). He was enthusiastic about coming and taping his Fox Business News show at this year’s FreedomFest and loves the topic “Are We Rome?” He told me he plans to attend as many panels, debates, and sessions as possible during the three-day show; you will have plenty of opportunity to shake hands with John and talk to him. He also will be autographing his latest book, “No, They Can’t: Why Government Fails, But Individuals Succeed” at our official Laissez Faire bookstore.

Two speakers at the Alexander Hamilton dinner, Ken Langone (co-founder of Home Depot) and Haley Barbour, former Mississippi governor, spoke on the importance of education, and how the system is failing, despite more than $1 trillion spent by the Department of Education. SAT scores still are falling, and the United States is ranked #17 in the world, down from its former #1 ranking.

Most of the speakers at the event attacked the teachers themselves, saying they are doing a lousy job. I think their criticism is misplaced. The teachers are operating under a defective system that does not encourage good teachers to succeed. As the Milton and Rose Friedman once said, we need to inject the right kind of incentives to encourage teachers to do better. The education system needs to be localized (not federalized), de-unionized (unions tend to be entrenched and self-interested), and privatized. We need more charter schools, more home schools and more private schools. We need more competition via vouchers or education credits. For more information, go to www.edchoice.org.

Special Announcement: I will moderate an “Austrian Financial Panel” at this year’s FreedomFest, July 10-13, 2013, with Adrian Day, Harry Veryser and Ty Andros. Sign up by going to www.freedomfest.com or by calling Tami Holland, 1-866/266-5101. Other speakers include Sen. Rand Paul, Steve Forbes, Wayne Allyn Root, Dinesh D’Souza, Grover Norquist, Steve Moore and hundreds more.

To read my e-letter from last week, please click here. I also invite you to comment about my column in the space provided below.

Upcoming Appearances

o Las Vegas Money Show, May 13-16: Join Jim Stack, Lou Navellier, former Fed official Robert McTeer, many other experts and me at this big investment conference. Tickets are complimentary for my subscribers. Call 1-800/970-4355, and mention code # 031168 to register as soon as possible for next week’s show.

o Good news! We confirmed Sen. Rand Paul, who could be the next president of the United States, to be our keynote speaker at this year’s FreedomFest. Join us there July 10-13, 2003, at Caesars Palace in Las Vegas.