People tend to look to the past to make sense of the present and the future. Examining historical patterns can indeed provide a useful roadmap for the future, but can sometimes lead to incorrect assumptions.
During bear markets, a hugely overused and, I believe, dangerous frame of reference is that of historical declines and their implicit assumptions about future market returns. For example, a widely used formula is: Recessions last on average w number of days and stocks fall on average x%, followed by a recovery of y% in z days. Market commentators use formulas like these to ease customers’ mental anguish and hint that better days are ahead.
Better days are ahead. However, they can take longer than expected and come with significant financial hardship.
The problem of averages
Averages tell us the central or typical value of a data series, but provide no window into the variation. For example, two cities may share an average annual temperature of 70˚F, but if one is in a temperate climate where the temperature is fairly stable and the other experiences significant seasonality, the average doesn’t tell you much. More data is needed to decide when to visit one city and when to visit the other.
Besides the problem of simple averages, just like the cities mentioned above, every market downturn, financial crisis and recession is different. Even if historical averages of market declines were accompanied by data pages, would that help? I do not think so.
Recessions wring out excesses
Economic and market cycles do not die of old age. They end when the excesses are corrected due to a financial crisis or recession. These, often painfully, squeeze out overinvestment both in the real economy and in financial markets. The length of the business cycle is irrelevant. What matters is the level of excess and the magnitude of the rebalancing process needed. This determines how far we still have to fall.
For a sense of past excesses, look no further than who was Wall Street’s favorite client at the time. For example, in the 1990s, it was the dot-com companies. The Street’s favorite (and most profitable) clients were internet-based concept businesses seeking capital. In the 2000s, the preferred clientele was financial institutions looking for a better return without excess risk. The Street sold them mortgage-backed securities consisting of repackaged loans issued to US homeowners who were unable (or unwilling) to meet their obligations.
The time it takes to heal from the dotcom bubble and the housing crisis is unrelated to the next recession. Different imbalances require different correction processes. The level of the decline of the S&P 500 or the MSCI EAFE at the time is no longer the problem. What matters today is whether the real economy and the financial markets have absorbed the excesses accumulated since the last recession.
Where are the excesses of today?
The policy response to the risks of low growth and deflation during the 2010s was quantitative easing. Central bankers expected it to lead to capital creation and corporate borrowing to finance productive activities. This was not the case, as the currency depreciation signaled producers of weak growth prospects. Instead, the borrowed money was used to pay dividends and buy back shares. Quantitative easing turned out to be the problem disguised as the solution.
Wall Street’s favorite clients in the post-GFC era were non-bank corporations. This group’s financial indebtedness reached new highs before the pandemic and surpassed those highs once central banks turned the lending tap back on in April 2020, unblocking credit markets.
As I wrote in April, despite the weakest business cycle in more than a century, corporate profit margins hit all-time highs in 2018, only to be surpassed in 2022 due to the lagged effects of overstimulated global economy. How? Debt is an increase in future capacity, and companies have raked in an unsustainable amount of margin and profit.
Margins and earnings ultimately determine stock and credit prices. “S&P 500 on track for worst start to year since 1970” is a dramatic headline but misses the point. What will drive future returns are profits.
Currently, many companies are telling investors that they can maintain unprecedented post-stimulus margins despite growing fears of recession and rising stage-dependent costs (which is why earnings expectations remain high in the face of obvious pressures on revenue and input costs), but we don’t believe them.
Risk is usually hidden in plain sight. What are your eyes telling you?
• Historical patterns can provide a useful roadmap for the future, but can sometimes lead to incorrect assumptions.
• Comparing past levies to the present offers little value. Each episode is unique.
• Companies are telling investors they can maintain historically high profit margins despite growing recession risks and rapidly rising costs. History suggests otherwise.
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