I’m a big fan of history. I study it. I love reading it. I find the patterns of the past fascinating. Both in themselves and for what they tell us about our own time and the likely future.
But…I just don’t think stock market history is a very reliable guide to the present and the near-term future right now.
I certainly understand why I’m seeing so many deep, intelligent, dives into market history at the moment.
We all want to know when the current selling will stop. And whether the selling that has produced a stock market correction will turn into a bear market. And what it means for our portfolios that the Federal Reserve is about to launch a long cycle of interest rate increases at the same time as it cuts back on its purchases in the debt markets as it winds down its programs to stimulate the economy (and the financial markets) and starts to reduce the size of its own balance sheet.
If history is any guide, I think you can make a strong case, as several big name money folks have done recently, that the market is way, way overvalued by any metric you choose to use. And that we’re looking down the throat of a very dangerous bear market triggered by central banks as they try to wring some of the excess that they created out of the financial markets.
The conclusion that the market is over-valued and that we’re looking at a vicious bear market are rooted in a clear reading central bank policy over the last 20 years. With each crisis in the financial system, central banks have pumped more money into the financial markets in any effort to stabilize those markets (and “real world” economies.) Each flood of cash has driven financial assets into an even more extreme bubble, which then necessitates another big infusion of cash in an effort to stabilize markets and economies after that bubble pops. Which then leads to another bigger bubble with an even greater danger of a bear market crash. Depending on how you count the current Pandemic-related stimulus, we’ve been through this same pattern in the Dot.com bubble, in the Mortgage-crisis/Global financial crisis, and now in the Pandemic recession.
I sometimes find it quaint that I can remember the days when the Fed ran a balance sheet of only $500 billion or so. The Fed ended the week of January 26 with $8.4 trillion of assets on its balance sheet. History says that it’s unlikely that a central bank can unwind a position of that size without sending repeated shock waves through a financial system. (History also suggests that the Fed might decide to follow the history of the Bank of Japan and NOT reduce its balance sheet. History doesn’t have very positive things to say so far about financial systems and economies where the central bank becomes the financial market for major asset classes such as government debt.)
If history is any guide, you can also make a strong case, as Wall Street money managers are busy doing right now, that a big cycle of interest rate increases from the Federal Reserve and other central banks doesn’t have to tank the stock market. Market returns in the year after the Fed begins to raise interest rates are surprisingly positive, historical data argues. Exactly how positive depends on how you slice and dice the time periods around a turn in the interest rate cycle, but history says investors aren’t looking at the end of the world.
The key phrase is, of course, “If history is any guide” and I’ve got my doubts.
First, there’s the Pandemic wild-card. I can’t find any historical examples of what the financial markets do when we have a simultaneous tightening from central banks and a lingering, unpredictable global Pandemic at the same time. The one period that I find roughly comparable in the unpredictable combination of two major “events” is the period right after the end of World War I when financial markets had the experience of trying to price in both the end of huge demand created by the war and the global influenza pandemic. But while I do draw some useful–I think–guidance from parts of that history (the world pretty much chose to ignore the last wave the flu pandemic because everybody was just too tired and it wound up being, consequently, as deadly as the worst of earlier waves–sound possible?) so much is different about the global economy and global financial markets that I’m not sure that any lessons from those years are applicable. Right now, we don’t know how much of current high inflation (you know what the world’s central banks have decided to fight with higher interest rates) has been created by the Pandemic and how long it will last. On more practical level for investors, we don’t know how much sales growth has been pulled forward (or delayed) by the Pandemic. Any idea of what the true 5-year growth rate for PayPal (PYPL) or Netflix (NFLX) is? Tough to put a value on a stock without a decent idea of a company’s underlying growth rate.
Second, there’s the sheer difference in magnitude in the size of central bank balance sheets, and corporate and government debt from where we’ve been at other points in financial market history. There’s an observation from military planning that says at some point the size of an army can be big enough to become a difference in quality. I suspect that trying to reduce an $8 trillion balance sheet by 50% is a significantly different task than reducing a $500 billion balance sheet by 50%. At the least the effect of a central banks’s moves on the real economy will be larger. And, I suspect, that the odds of a meaningful policy error with very large effects also increases substantially.
Third, there were troubling trends at work in the U.S. and global economies before the Pandemic and they haven’t gone away. There’s, for example, the puzzling leveling off (or perhaps it’s a drop) in productivity growth in the U.S. economy. No one is sure where all of the delicate comes from. But a slowing of productivity growth has huge implications for the “speed limit” growth of the domestic economy–with slower productivity growth, you’d expect inflation to move dangerously higher at a lower level of GDP growth. Globally, of course, there was the problem of aging populations in the world’s developed economies and, very importantly, in China. Aging populations have, historically, meant slower economic growth as economies lose the benefits of a “youth dividend” that comes from more young people working and a smaller percentage of the population requiring the extra spending that older folks require. And, we were just starting to explore the implications and possible solutions for those economies with rapidly aging populations and insufficient retirement savings. China is the key example of this right now.
Fourth, global warming will have massive effects of global economies that will, net/net require greater capital spending and will see big hits to growth and production of key commodities. (Another way of saying, the world’s food supply is going to be really challenging as rainfall patterns shift and temperatures result in the spread of new pest and struggles to adapt food plants to tougher growing conditions.) To take just one financial market challenge resulting from global warming and efforts to contain its effect within something like a tolerable range, what happens to all the fossil fuel assets–and the debt that they support–if (as I think is likely) companies have to leave some oil and natural gas (and coal) in the ground in order to stave off complete global disaster? Think that might lead to wild currency swings? Or to really extreme extra-market efforts to make up for “lost” revenue? Or central bank mistakes because, hey, how do you put this unprecedented global crisis into your inflation and employment models?
When I started this post, I thought I’d merely lay out some of the reasons for thinking that financial market history might not be a reliable guide right now.
Having gotten this far in the topic, though, that seems an inadequate response to the problem: If I’m right and financial history doesn’t give us much guidance, what does? And what can we expect in the next five to ten years? And what should we do as investors during that period?
I guess that’s the topic for one of my posts tomorrow. (Along with the meaning of life–and the earnings reports from Meta Platforms (AKA Facebook), PayPal, Intel, Advanced Micro Devices, and Google (AKA Alphabet.)