Criteria to spotting the next financial crisis

Man, I didn't see that coming. Ever said that before? I have. September 2008. Right after AIG went down ­— and this was six months after Lehman Brothers' bankruptcy, so I should have at least been on notice. The S&P 500 stock index touched 666 the following March (today, the S&P stands at 2,450).

Could I have seen it coming? Could I have predicted the crisis? Can anyone? I think the answer is broadly "yes." So how does one go about crisis spotting?

Before we begin we need to define a crisis. I define it as pronounced and perhaps sudden economic downturn caused by problems with liquidity, credit, currency and/or employment, although this is not an exhaustive list. Although a recession or moderate economic downturn is not a crisis per se, your spotting mechanism should still pick this up.

So, here's how I go about trying to spot a coming crisis in four easy steps.

1. Start with the macro.

Where are we in the business cycle? It's easy to dismiss this simple indicator as obsolete — and I will concede that "recent" (as in the past decade) unprecedented monetary policy has perhaps extended the business cycle — but it is still very relevant to crisis spotting.

Our economy has definitely progressed from the cataclysmic days of the Great Recession. The economy is expanding, and we are seeing the growth in jobs and wages (mostly) we expect from this stage of a recovery.

Business cycle assessment: Above average risk of crisis

2. Develop a view on interest rates.

If rates are rising, there's trouble on the horizon. The level and future path of interest rates is probably the single biggest factor in crisis spotting. Warren Buffett recently stated that "if interest rates stay this low, stocks are cheap." In other words, the level of interest rates dictates asset valuations (in this case the stock market) and valuations are a key factor in the development of asset bubbles, and asset bubbles (eventually) lead to crisis.

The Fed is clearly in a tightening cycle and is planning to reduce its $4.5 trillion balance sheet, which — in addition to the federal funds rate targets increases slated for the balance of 2017 — will remove a significant amount of monetary accommodation from the system.

So where do we go from here? Either higher, lower or nowhere is the correct answer (pure genius). However, that's the wrong question. We should be asking, what is the probability of these outcomes? I currently believe that higher interest rates are more probable given current Fed policy.

3. Assess the health of the consumer.

One way or another, the effects of economic activity, interest rates, price levels and the cumulative impact of government policy is born by the consumer making your view of the economic health of the consumer a critical component of crisis spotting.

The U.S. economy is basically at full employment. Median incomes have been rising, albeit stubbornly slow, since the Great Recession. Wages should continue to rise, although the pace and duration of such is far from certain.

However, consumers have incurred a record amount of debt. Student loans, auto loans and credit card debt have exploded with all three at or near all-time highs.

Yet, delinquencies on consumer loans remain at historically low levels. Delinquencies have begun to rise in the past year with significant increases in subprime auto loans and credit cards, but this is not currently overly worrisome.

Consumer financial health assessment: below average risk of crisis

4. Make and update your assessment as to the likelihood of a coming crisis.

Finally, synthesize your findings and reach a conclusion regarding the current risk of a crisis.

We are not talking about pinpoint accuracy but rather a high-level assessment of the current conditions. Think about it like those weather forecast graphics you see on TV or your mobile app. You know where it goes from just the sun, to the sun and a few clouds, to a lot of clouds and some rain to the one with the dark clouds, rain, lighting bolts and that graphic of the person blowing in the wind. Which is it for you?

My conclusion is that there is currently an above-average risk of a crisis (or recession).