The Dow shed 37% in less than six weeks after mid-February as the severity of the coronavirus pandemic sank in. It has since recovered some ground, but stocks continue to be volatile.

What lessons could investors and policymakers learn from the latest market crash, compared with previous slumps? Could quantitative finance models be used to anticipate and prevent the next crash? In all market crashes, “the commonality is the fear, the moment where people just drop their models, drop their common sense, and they just walk away,” said Wharton professor of finance and economics Joao Gomes in a recent interview with Knowledge at Wharton. Quantitative models bring a disciplined approach to trading and valuing assets, but they would not have helped predict or prevent the latest market crash, he noted. That, he said, is because the trigger was policymakers deciding, along with society at large, to shut down large parts of the economy to contain the pandemic.

Quantitative finance could help predict future crashes, but investors must remember that such models are “written by humans, and they have margins of error, potentially large,” Gomes warned. Also, investors may repeat the same financial mistakes. “Collective memories are relatively weak and short, and the next generation will soon move on and get past it,” he said.

 An edited transcript of his interview appears below:

Knowledge at Wharton: A lot has been written about free-lunch investment strategies that led to the formation of market bubbles, which eventually burst and destroyed enormous value. Do you see any similarities between the subprime market crash of 2008 and even previous crises, and the most recent stock market collapse as a result of the COVID-19 pandemic?

Joao Gomes: Certainly, there is an obvious parallel to [previous market crashes], particularly those in 1987 and 2008. What is probably different [now] relative to 2007-2008 [is that] in 2007-2008, there was a slow, building consensus that the market was probably getting inflated. I don’t know if we want to use the word “bubble” or not, but there was a sense among investors that things were getting a little bit out of hand. In retrospect, there were some clear symptoms, I would say.

I don’t think that was true in 1987. It was more of a technical issue that triggered a very brief collapse, [and] the market rebounded relatively quickly. Even though we were perhaps somewhat convinced that valuations were rich, I do not think there was the sense that a recession was coming, that things were getting out of hand, and that credit was too cheap. The economy was humming along at 2% to 2.5% [GDP growth]. Credit was maybe slightly generous, but there was no sense that pressure was building.

Coming into the present collapse, the story is different. This is a collapse where we just chose from a policy standpoint to shut down the economy, and that brought everything else down with it. Nobody could have anticipated that going into this year. In terms of the panic that you see with the economy, 2008 is the closest comparison – the proportions of the collapse became an incredibly large event.

[As for] the unfolding of the crisis, we will have to see. The legacy of 2008 was a huge debt problem for millions of households that took a long time to clear up. Banks had serious solvency problems that needed to be addressed. There was also a crisis of confidence, not just in the economy, but in the financial markets overall. Now, it is quite different in ways that we don’t yet understand. [How] they will play out is completely contingent on the pandemic and how it is going to be dealt with in the coming months.

“In all different episodes, the commonality is the fear, the moment where people just drop their models, drop their common sense, and they just sell. They just sell and walk away.” –Joao Gomes

Knowledge at Wharton: Could you dial back further to the 1987 October crash or the Long-Term Capital Management hedge fund collapse in 1998?

Gomes: A collapse like the one in 1987 occurs when the economy, both before and after, is doing well. I would call that a “technical collapse” in the sense that investors were caught off guard by trading strategies that amplified stock market fluctuations, fed on themselves and produced a massive crash when there was no fundamental reason for that to have happened. But it took some time to understand exactly what happened.

[The 1987 collapse] was a little different. It did not have, certainly, the increased economic damage of 2008. It did not really harm the economy. But it was a scary event. The actors responded, but the economy got out of that relatively unscathed. LTCM has the same similarities – all three of those events have those similarities. They are just panic moments when the market suddenly realizes that things that were not planned for could occur, and they could be exceptionally large and destabilizing.

When LTCM [collapsed], it was dealt with quickly. A few banks, encouraged by the central bank, got together, bailed it out, and put an end to the threat to credit markets and the rest of the economy quickly. It lasted a week or two. It was scary, but it quickly got under control. The markets got to the point where they understood the risks. They understood the resolution, and there was no reason to think that it would escalate. [It was] a different phenomenon, and it didn’t do serious damage to the economy. But it was another example of how something totally unexpected that we don’t understand could, for a little bit at least, put an end to rational trading and pricing that we see most of the time, and lead to a sheer panic that we would see a collapse in asset prices.

In all [such] episodes, the commonality is the fear, the moment where people just drop their models, drop their common sense, and they just walk away.

Knowledge at Wharton: One feature that is common to these crises is that all of them involve positive feedback loops that reinforce the fantasy of exceedingly high returns at low risk. Do you think there was any evidence of this before the current crash?

Gomes: There was a little bit of that, for sure. Early this year, there was virtually no one who thought we would have a recession. It was dangerously overconfident. Middle-to-late last year, there was a slowdown, and people got a little bit nervous. But coming into this year, everybody felt that was done, that was over, and the economy was going to have a good year. This was a presidential election year. There was not going to be a recession of any type. Unemployment had stayed exceptionally low. Interest rates were not going to go up. There was complacency. The perception was that the risk was about as low as it could be.

[However], there was some sense that market [valuations] may be rich. Maybe it is down to where it should be for some people. But there was not a sense that you want to get 10% a year every year, or at least for the next two years – and that you should absolutely buy. I do not think that was present at all like it was, say, in the housing market in 2005 or 2006.

Knowledge at Wharton: Could the principles of quantitative finance have helped anticipate the present market crash? If so, could anything have been done to prevent it?

Gomes: That is an interesting question, too. The story of this current market crash probably is going to be rewritten several times, but it is hard to deny that something dramatic happened to the economy between February and April. It is not just that our mood changed; we literally shut down a quarter to a third of the economy. A lot of businesses are not generating profits anymore. I don’t think anybody could have anticipated that.

It is a crash that is induced by something real. It is not just fear. It is not just that [we] woke up one morning and said, “I don’t think the world is a happy place anymore, and I’m going to sell my stocks.” There’s something different about this that was both hard to predict, or impossible to predict, by, I think anyone, except maybe in some model of academics. But virtually no one thought that was going to be this serious.

So, I don’t think quantitative finance, or any type of business toolbox would have helped [avoid] this particular crash. This was a crash of will, largely, and politicians – the policy-makers – decided that. The society at large probably decided that, or forced them to do that, [and felt] it was worth paying this very large economic cost to shut down this epidemic.

This question is something we will revisit a year or two from now when this is over – whether this was worthwhile or not. But people decided it was worth paying literally trillions of dollars to do. I do not think there was anything particularly irrational about it. I think the crash itself probably was larger than it should be.

Quantitative finance is mostly a discipline that [involves] serious scientific tools that should tell you how you should trade and value assets. It would probably have helped in the sense that the rationality and the common sense that is embedded in the disciplined approach would have capped some of the panic and the crash to somewhat more reasonable numbers.

What we have seen over the last few weeks is this huge zigzag, where people are just thrown up and down in their moods, in some sense trying to figure out what’s happening. In part that’s because we are just not disciplined enough, and we are trying to learn from each other, as opposed to relying on some sort of long-term view of where the economy is going and what the prices should look like.

“This was a crash of will, largely, and politicians – the policymakers – decided that.”— Joao Gomes

Knowledge at Wharton: What is your assessment of where the markets are today? Where do you see the most significant risks?

Gomes: The most significant risk is that the epidemic will either not go away with these measures quickly enough, or that it will return much more seriously in the fall, and we will not be ready for it. The epidemic itself is problematic, but it is not massively so. The real problem for financial markets is that businesses are not making any money. Nobody is buying anything except toilet paper and canned beans or something. So there are lots of businesses that are just shut down right now, and the market is rationally saying, “Well, if you’re not making sales, if you’re not making money, there’s no reason to actually buy [your stock]. I’m not going to get any dividend, any compensation for the asking of these businesses right now.”

The main risk is that the epidemic will be perceived to be so dangerous to our existence that we continue to shut down large sections of the economy for extended periods of time. Eventually there is nothing we can do to mitigate those costs. We have done a lot of short-term things. I would describe them as sort of “bridge loans.” We are providing loans while you don’t have any money. That works for a while, but that cannot work forever.

Knowledge at Wharton: How do the risks in the U.S. compare to those in Europe and Asia? And what are the implications for global investors?

Gomes: From a scientific standpoint, of course, the underlying risk is probably similar. The main benefit, perhaps, for the U.S. is that it might be easier to manage it because it is one single, big country. Or it might be easier to control it to specific places and to manage resources. It is extremely hard to answer, honestly.

We have one great advantage over Europe and Asia, which is the dollar. And because of that, we can be much more aggressive in lending to businesses and to municipalities and for the federal government to send you 1,000-dollar checks. People like to hold dollars. They like to hold U.S. government bonds. They like to lend to the U.S. They do not like to do that to a bunch of European countries.

It is easier for us to [respond to] the economic damage by saying, “I can bail you out.” At least for a few months, I can bail you out. It will not last forever. That is probably the biggest difference that makes the risk in the U.S. overall smaller. We just have more powerful economic tools than Europe and most of Asia – possibly not China.

Rebounding with Strength

Knowledge at Wharton: In addition to risks, every crisis also presents opportunities. What strategies do you think institutional investors should pursue today to preserve wealth and to benefit from the upside, once the markets recover? What strategies do you think are most likely to outperform the market?

Gomes: The crisis has dramatically changed the value that consumers and firms place on certain types of services and activities, and some strategies that will do better than the market. First and foremost, you have to keep a long-run perspective. Things are changing every day, and you can overreact to lots of things, but you have to plan out [for] when this is over. Eighteen months from now, two years from now, what will the new world look like? Which sectors are going to outperform and appeal more, and produce more things that people want to buy? It seems clear that people will be much more health-conscious and much more nervous about interacting with one another in public settings.

There will be more demand for basic tools of hygiene in public places. Shared office space, for example, is going to be furiously reconsidered. Firms like WeWork should be problematic investments now. The idea that you are going to be in close proximity in an open space with a bunch of your co-workers is going to give people pause. Public transportation is going to be a problem.

Obviously, real estate is a big question. Do people really feel comfortable in shopping malls? Is this accelerating the trends towards shopping at home more and more? Obviously, anything to do with IT and anything to do with working remotely using technologies [like] Zoom will be incredibly important. Will people want to work more from home now that they are used to it? Where should coffee shops and small businesses be [located]? Should they be close to homes or close to the workplaces? Thinking about what this world will look like, what will consumers want to do? What will businesses want to do two years from now? The scars of this crisis will be with us for many years.

“We’re just not disciplined enough, and we’re trying to learn from one another, as opposed to relying on some long-term view of where the economy is going to go and what the prices should look like.” –Joao Gomes

Knowledge at Wharton: Would you say something similar applies also to the transportation industry, since airlines and others may also be affected for the same set of reasons that you described?

Gomes: Absolutely – yes. [It will depend on] the willingness to share [spaces] and how comfortable people are going to be sharing bus rides, or transportation in general. Generally, public transportation is unlikely to be popular in the coming years, and that will change the way people think about either working from home or driving more.

Airlines are a little harder for me [to predict], only because I still remember 9/11 and how we thought about the airline industry as being completely different after 9/11. And it did not really happen. We saw lots of restructuring and merging of airlines, but air travel rebounded. In retrospect, you would not say that crisis transformed the industry. It certainly changed things in the U.S., but there are so many people around the world who do not travel by air. There is so much potential to grow, from Asia in particular. I am not sure I will be pessimistic on airlines – cruise ships for sure, but airlines, I don’t know. I suspect that it will continue to be popular in the next decade or so. The experience might change. It might be that people demand a lot more. They are a lot more concerned about germs in general, and they just may demand a different level of service and care. But I am not sure that is going to be that different than the added security we saw post-9/11.

Knowledge at Wharton: Bruce Jacobs (principal and co-founder of Jacobs Levy Equity Management) has said that misconceptions and gullibility cause some investors to make the same financial mistakes over and over again. They fall for the same flawed narratives about risk management, liquidity, and leverage. Why does this keep happening? Will the severity of the present crisis teach more enduring lessons about the illusion of free lunches?

Gomes: I would only change one thing in what you said, which is I do not know if it’s the same investors. I think it is different investors. Each generation of investors makes the same mistakes as the past generation. I do not think there will be enduring lessons. There will be lessons, and through the analyses we will remember them, but the main problem is collective memories are relatively weak and short, and the next generation will soon move on and get past it. Policymakers will learn a lot, hopefully, and they will learn how to deal with this crisis and make sure that the next time something like this happens, we’ll have a much better response far out. But the next generation of investors will make the same financial mistakes for certain. We have seen that repeatedly. I see no reason why it will not happen again.

Knowledge at Wharton: In fairness to Bruce Jacobs, he said, “Some investors,” rather than “the same investors.” The mistakes are the same, but the investors change. He also wrote that “seemingly rigorous mathematics, plausible theory and early performance success have proved time and again to be a dangerously enticing cocktail.” What do you think is the antidote to this toxic mixture?

Gomes: The interesting thing about that quote is that it can apply to lots of contexts, including the current diagnosis of the epidemic and its outlook.

You look at all these models of what is going to happen, and it is exactly that. They are seemingly rigorous, and most people do not really understand them. [They are] plausible, and they have some backtracks that look great. So, we make all these projections about what is going to happen – it is irresistible in this environment. It is the same thing in financial settings. We are dealing with just fantastically complex tasks. They appear chaotic, and we just need some order. We try to ask people who we think are experts and try to come up with models of what is happening. The only thing we need to do is just do a lot of them, have different models, different views, and have a range of what could happen from them. But the alternative to it would be that just you and I talk aloud – with no organizing principle.

What I would take from the [Jacobs] quote is it is always important to remember about everything we do in the old scientific context, and that includes things like projecting epidemics [and] climate change. You should be aware that there is a margin of error, and just because it is a set of mathematical equations that worked well in the past does not mean that it will work well in the future. These things are extraordinarily complex, which means there are a lot of things we do not understand, and they could change. And so, that is the antidote – to always remember that these models are not written by the gods. They are written by humans, and they have margins of error that are potentially large. They are just the best way we have to understand what is going on, but they are not infallible by any means.

“These models are not written by the gods. They are written by humans, and they have margins of error that are potentially large. They are just the best way we have to understand what is going on, but they are not infallible by any means.” –Joao Gomes

Knowledge at Wharton: Looking to the future, do you think quantitative finance can help predict future crises? If so, what can be done about it today?

Gomes: Absolutely, yes. I have lived through several of these crises. [With] most of them, many of us were saying that there was a problem here, that something should be done, that markets were too hot and something should be done with some particular prices that were just out of line. The problem was it was a minority, and it’s very hard to convince people to sell when the price is going up. I think that it’s very difficult because a lot of people do not use this disciplined approach of writing down a good story, a good model, a good argument for what is happening, validating it repeatedly, writing several alternative stories and just convincing themselves that “I have 10 different models of how this could play out, and none of them comes anywhere close to what we are seeing right now. And so sooner or later, something is going to break.”

[That approach] has helped me. It has helped a lot of people avoid being caught in the middle of this crisis. But you must remember that it is not just you. There is no point trying to stand in front of the stampede, right? You are just going to get crushed. [Quantitative finance is] immensely helpful for predicting crises. But [one] element of a crisis is that suddenly people wake up and realize, “The king is naked, and this is not going to work.” And you just cannot predict that. That is an emotional response to data. You can be positioned for that day, but whether that day arrives this month or a year-and-a-half from now is much harder to predict. That is not really a quantitative finance exercise. That is when people in general come up to your point of view and agree with you.

But it is a great set of tools that we are hoping will equip people to make rational decisions. That is why we thought that this is something we wanted to do in our school in a much more forceful way. We keep seeing these episodes, and we keep seeing a very casual approach to mostly observing and documenting markets. There are many schools out there that could help prepare people to be in a very comfortable position to just ride the crash and not feel like their wealth is being wiped out, and feel in a comfortable position to take advantage of great opportunities during the rebound, and that they focus on the big picture, the longer picture. That is the key to immense wealth for a lot of people. That is something that hopefully our students will get from now on.