As humans, we crave to understand things. It’s part of our survival instinct. We don’t cope very well with not understanding something and our minds have a way of spontaneously generating plausible explanations – “jumping to conclusions”. At the point we feel we understand something, our brain releases hormones that make us feel good.
When it comes to investment markets, we’re dealing with money – opportunity to make money and also to lose money. Given this, there’s a really powerful desire to understand. Frustratingly, investment markets are full of irrational things that don’t mesh with our human need to understand.
At any given point, and especially in a market environment like the current one where uncertainty is high, there’s generally a “narrative” – a logical explanation as to why whatever is happening is actually happening. The title for this piece comes from one of the popular narratives at the moment in order to explain things like this chart:
(Source – Bloomberg via Zerohedge)
The narrative goes something like this:
“Yes things look terrible at the moment… things are terrible…the global economy is locked down… economic data is woeful … corporate earnings will surely take a huge hit over the coming few quarters…but with light now at the end of the coronavirus tunnel, investors are willing to look through the next 12 months or so to the other side.”
I don’t actually have any great objection with this – how can I? It’s as good a reason as any to explain why share markets are not reflecting today’s reality. But, what I do have major reservations with is the sustainability of this narrative. Oh, and there is another major part of the current narrative – we’ll get to that in a moment.
Today I want to test the current narrative, have a look through history, compare it to now and see whether we can get any sense of what the months ahead may have in store. For a bit of fun, we’ll make this a little bit interactive…
We’ll start with the key bullish argument at present – the “other” major part of the current narrative;
“Don’t fight the Fed!”
I’ve covered “Quantitative Easing” at length multiple times over the past decade however it is so important at present that its worthy of a revisit.
QE is in essence buying bonds. So as a start, who exactly owns US government debt. Here’s a snapshot
Tucked within pensions and monetary authorities are the largest individual holders of debt. The biggest individual holders are in fact US government entities – the Social Security Trust Fund.
With that in mind, why do people invest in US government debt?
For the largest holders the answer is essentially “they have to”. These major investors are under strict investment mandates. And no, the government does not force them to buy their debt in order to create demand so they don’t go bankrupt! It’s simply part of their risk management strategy – managing potential losses and also liquidity.
How about foreign holders? Why do they hold debt? Well, basically for the same reason – the US dollar and debt markets are the only markets deep and liquid enough to park their accumulated reserves. It’s not necessarily because they want to invest in US government debt but they have relatively little choice.
Say you’re a central bank… say China’s… you run a major trade surplus with the world, and with the USA in particular. You are therefore experiencing significant inflows of US dollars. In the simplest sense you need to park these surplus funds somewhere. They are a “financial asset” and need to be held by someone at all times. You can exchange them for other currencies, but it must be an “exchange” – someone needs to have a pile of the other currency you would prefer to hold and be willing to trade.
Convert them into Chinese Yuan? Well yeah, that implicitly has already happened by the businesspeople that brought them in from foreign sales. But the US dollars are not “destroyed” in the exchange – someone has to have exchanged their Yuan for them and now be the proud owner of US dollars.
Through the mechanics of managing their currency, what we’ve seen over the past 20 years is the Chinese central bank has become the holder of many of those US dollars. Again, they can rid themselves of them by exchanging them for another currency. But the numbers are just too large – where else could they park gazillions of US dollars? As I’ve said before, don’t fret about China dumping their US debt holdings. It would be fun to watch them try – it would be a little destabilising to markets but the US will be just fine.
We’re digressing well away from QE here, however, the concepts of “financial asset” and “exchanging” are very important to all this QE stuff.
Now… “Quantitative Easing”. An unconventional monetary policy tool which first appeared during the 2008 financial crisis.
There’s basically two goals with QE. The supposed main goal goes to the heart of monetary policy – setting the “price of money”. Pressure bond prices higher and the effective interest rate reduces. Just like they do all the time as part of their “open market operations” – balancing liquidity in the interbank market so that the effective interest rate reflects their official target interest rate. Perhaps the main difference to normal operations is that central banks are normally just concerned about the short end of the curve – overnight rates in the interbank market. During QE the Fed often targets longer- term rates such as 5 or 10 year bonds.
The second goal is to provide liquidity to debt markets so that they function “normally”.
It’s the pursuit of this second goal that’s raising the eyebrows of many market participants at the moment. The Fed is wading into more markets than ever before such as corporate debt. The question is what’s normal? The US economy has shut down. It’s entirely “normal” that financial assets tied to the US economy will be experiencing a difficult period, just like the economy. But thanks to Fed interventions, some of these markets simply don’t reflect reality. Great. Well done Fed. “Normal” markets.
The Fed can intervene in debt markets and therefore truly manipulate prices. But just in case there’s any confusion, the Fed cannot and does not buy equities or any equities derivatives such as ETF’s and futures.
There seems to be some excitement that the Fed might start to buy equities at some point. It is illegal under their current governing rules, but sadly if the Fed really wants to recklessly pursue a takeover of share markets, I feel there’s a real chance that clueless politicians will be easily convinced that it’s in the nation’s interest to change Fed governing rules. Or given the state of modern politics I regrettably think “selling” a Fed takeover of the stock market to politicians is as simple as saying to them “this will benefit rich people…you are a rich person”.
When it comes to QE, it’s understandable that it’s still quite poorly understood. As an example, I was a little surprised to read some analysis from a veteran commentator that I quite respect where in essence he said:
“The Fed continues to engage in QE, creating more and more reserves in the banking system… because these reserves are not needed some are flowing into equity markets.”
No! There’s several things wrong with this:
Firstly, the “flow” thing. Say I have $1,000 of cash. No, let’s call it $10,000,000. I call up my stockbroker and arrange the purchase of $10,000,000 worth of shares.
Once the transactions settle, how much money has “flowed” into stocks? By how much has “cash on the sidelines” reduced?
I hope your answer is zero… All that’s happened is I’ve swapped my cash for someone else’s shares. “Exchanged” if you will. I have their shares, they have my cash.
The point is that every financial asset in existence needs to be held by someone at all times until it is retired. Every share. Every bond. Every house. Every dollar. Every asset. Money doesn’t flow out of bonds and into stocks. Money doesn’t flow out of “growth shares” and into “value shares”. This concept is very important in the understanding of Quantitative Easing.
Now, let’s explore the transactions involved in “QE”. The central bank wades into the bond market. It buys bonds. It pays for those bonds by “printing money”.
By how much has the private sector “net financial assets” changed in the transaction?
I hope you again answered “zero”. It’s just another asset swap – the central bank now owns the bonds and the private sector has cash instead of bonds.
It’s at this point we really need to focus… There’s a view that all this new money needs to go somewhere and is flowing into the stock market. Let’s examine this carefully.
The central bank buys bonds in the open market. Who are the sellers? Well, whoever they normally are! They are incredibly deep markets – there’s always people wanting to buy and sell for whatever reason. The Fed can’t “force” anyone to sell. (As an aside, this is not 100% true as primary dealers are obligated to trade with the Fed, but that’s not particularly relevant.)
But just for illustrative purposes, say the Fed can force people to sell bonds to them. Say as a private investor you hold $10,000,000 in US government bonds. You get a knock on the door. It’s the Fed – they inform you they are compulsorily acquiring your bonds for the good of the nation. They pay you a fair price… a good price.
Now what? You have a mountain of cash. What do you do? Do you just go and dump it in the share market?
If you answered “yes”, what’s your reason? And why didn’t you sell your bonds previously and buy shares? They are hugely liquid. The Fed didn’t just do you a favour buying them – you could have sold them at any point anyway. Why would you just go and buy shares? The point I’m trying to illustrate that if you think about it this must be the case with every bond holder. If your bonds are exchanged for cash (whether via the Fed or not) you have a decision to make as to what to do with the proceeds. You can choose to put in in the share market (provided of course you are an entity that’s allowed to invest in shares). But it’s an asset allocation decision that comes with risk and reward. For no participant is putting money into shares a “risk free bet”. Nobody.
But it seems to juice markets – how?
There’s no doubt that making money-markets hugely – excessively – liquid is broadly a “positive” – both for those market and the share market. The way in which QE does have a true effect on the share market is via that manipulation of interest rates.
The interest rate on government bonds represents your risk-free benchmark. All asset allocation decisions are (or should be) derived from these rates. Therefore, it’s true that if QE artificially suppresses risk-free yields, it will have the effect of making other risk assets relatively more attractive. But once again, a decision to chase a higher return in the stock market comes with risk for all participants. All participants – nobody is being given free money they can lose without consequence via QE.
We’re obviously dealing with some really hardcore, abstract finance stuff here. I hope I’ve been able to make my points:
QE is merely an asset-swap.
Suppressing yields on other financial instruments can result in other assets looking more attractive.
But investing in shares comes with risk for all participants.
And therefore the view that “QE makes share markets go up” isn’t a fair conclusion.
If holders of shares become “risk averse”, the fear of sustaining capital losses will induce them to sell, no matter how much QE the central bank is doing at the time.
Throughout the brief history of QE, there are clear correlations between central bank balance sheet size and equity indices. But correlation doesn’t necessarily mean causation. My view is that there will come a point in time where the correlation breaks and investors lose faith in the Fed. Given faith in the Fed seems very high, it could be pretty ugly. There’s loads more I could say about QE however there’s other things I really want to address today so let’s move on.
What’s a “recession”?
For those Australians under the age of 35, a “Recession” is basically a period in time when the economy is not going real well. In defining a recession from an economics perspective, most of us are familiar with the “classical” definition of a recession – being two consecutive quarters of negative GDP growth. Economists however have long argued that this is too crude a measure.
In the USA, the entity charged with the task of formally identifying recessions is the National Bureau of Economic Research (NBER), or more specifically, their delightfully-titled “Dating Committee”.
The committee has been around since the 1920’s and is comprised of around nine academic economists – basically a “who’s-who” of the nation’s most respected professors at the time from the most prestigious universities.
The committee maintains a chronology of the US business cycle – a bunch of dates representing peaks and troughs in economic activity. Within this, they define a “recession” as a period between a peak and trough. Here’s a summary of what they look for – straight from their website:
During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year. Similarly, during an expansion, economic activity rises substantially, spreads across the economy, and usually lasts for several years.
In both recessions and expansions, brief reversals in economic activity may occur – a recession may include a short period of expansion followed by further decline; an expansion may include a short period of contraction followed by further growth. The Committee applies its judgment based on the above definitions of recessions and expansions and has no fixed rule to determine whether a contraction is only a short interruption of an expansion, or an expansion is only a short interruption of a contraction. The most recent example of such a judgment that was less than obvious was in 1980-1982, when the Committee determined that the contraction that began in 1981 was not a continuation of the one that began in 1980, but rather a separate full recession.
The Committee does not have a fixed definition of economic activity. It examines and compares the behaviour of various measures of broad activity: real GDP measured on the product and income sides, economy-wide employment, and real income. The Committee also may consider indicators that do not cover the entire economy, such as real sales and the Federal Reserve’s index of industrial production (IP). The Committee’s use of these indicators in conjunction with the broad measures recognizes the issue of double-counting of sectors included in both those indicators and the broad measures. Still, a well-defined peak or trough in real sales or IP might help to determine the overall peak or trough dates, particularly if the economy-wide indicators are in conflict or do not have well-defined peaks or troughs.
Below is a snapshot of recent US recessions together with some other interesting data
If you compare the recession timeframes with quarterly GDP data, you won’t necessarily see GDP contracting all through the “recession”. Indeed, there might be month-over-month improvement in the data through the duration of the recession. This is reflective of the NBER’s explanation of how they define a recession.
I’ve been thinking a lot about the financial outcomes of coronavirus. As I’ve discussed in recent months, there’s little precedent to this event. We already know the US economy is most likely going to enter one of those “technical” recessions (2 consecutive quarters of negative GDP). But judging from history, it will likely linger a lot further than that. Or will it?
What do you think?
Exercise 1: You are a Junior, Probationary, Assistant Portfolio Manager at Aviator Capital. The desk head is leading a brainstorming discussion about the current US economic environment and how things may play out compared with other recessions. He’s asking for everyone’s sense of where, in hindsight, the numbers will be.
Complete the following:
Recession Start
Recession End
Length of Recession (Month)
Have you got your answers? You are welcome to answer “not applicable – US will avoid recession thanks to the Fed” if you want.
Moving on…
When it comes to longer-duration market movements, we know there is one incredibly important input – valuations. It’s simply common sense – the higher the price you pay for an asset, the lower your prospective returns must be. Said slightly differently, the higher valuation you buy at, the lower your prospective returns.
It therefore follows that comparing where current valuations sit from a historical perspective at any point is incredibly informative.
We know there are all sorts of different valuation models – many of them being quite simple. The most common examples are the good old “Price/Earnings” ratio. And of course many commentators like to rotate between different models depending on which one/s best support the argument they are presently trying to make!
For example, back to our “look-through” narrative. The “current P/E” or “12 month forward P/E” makes shares look very overvalued. “Yes! But on the basis that the economy and corporate earnings will massively recover over the next couple of years… the 2-year forward P/E looks just fine!”
Most of these simple models are pretty useless – with a little data-crunching effort it can be shown they have very limited predictive powers. It’s better we use a model that demonstrably has some serious predictive powers.
And why go to the effort of building something when people smarter than us have already done the hard work. US-based funds manager Dr John Hussman is a prolific datacruncher. He’s tried every conceivable valuation model to test its usefulness and in doing so, identified those models that has proven to have the greatest accuracy.
The green line in the chart below represents “fair value” for the market using a valuation formula that has proven to have a very high correlation with the actual market over the longer-term. The blue line is the S&P 500 index.
The first observation we make is how breathtakingly detached the market presently is from “fair value”. How incredibly overvalued it is. No more banging on about that today – let’s move on.
I’m more interested today in looking at what’s happened to the market in previous recessions. When we compare the chart above to the earlier data on recessions and market drawdowns in recessions, we can make some interesting observations.
I’ve added the yellow bars to mark some of the recessions as identified in the earlier table. The two furthest to the left are the 1953 and 1960 recessions. The bigger one in the middle is the twin recessions of the early ‘80’s. The two on the right are the most recent US recessions being 2001 and 2007. Go back and have a look at the peak to trough fall in the market. Then take a closer look at the chart above.
Notice that most of the time – not always – the market fell less during a recession when valuations were not far from “normal” to begin with. Conversely, notice that the largest falls occurred when the market was significantly overvalued going into the recession.
Oh, and just to clarify, if the market was to tag that green line like it did in 2009 (I stress if as there’s no predictions being made), that corresponds to around 1200 on the S&P 500. Just sayin’…
Those of us who have been through a full cycle or two also have a sense of what the current market environment usually brings. Great uncertainty. It brings volatility as the market gyrates between hope and fear. Central banks can interfere to suppress volatility but as described before they cannot eliminate risk and the natural human emotions that still to a large extent dictate short-term market direction.
How do markets behave in times of recession/uncertainty? Well, here’s a little snapshot of the market during the global financial crisis (thanks again to ClearBridge):
Now, I’m not saying that I think the market will ultimately fall around 60% in the end over a period of 16 months like 2007. But it might.
The market has rallied spectacularly since the march lows. I see commentators now talking about how long it will be till it makes a new high. Maybe it does. But one key point I wish to make is that market rallies – some lasting 30 or 40 or 50 days – are common in recessionary periods. (Be careful with what you might be thinking right now… we need to be counting only “trading days” not calendar days!)
Are the lows in?
Exercise 2: The discussion in the Aviator investment committee meeting has moved on from guesses surrounding the possible length of the US recession to a discussion about the market. Observations are made about prior experiences and how the circa 35% fall in the S&P 500 during March fits with historical precedents. Various valuation models are discussed. Everyone is asked for their guesses. Completing the following:
Recession END
Market Low (Month)
S&P 500 Peak to Trough
Nobody knows what the months – the years – ahead hold. As is the case most of the time, history is perhaps our best guide.
The average recession since the ‘50’s has been 10.5 months.
The market has tended to hit its lows around 4 months prior to recession end.
The average market drawdown during the last 11 recessions has been around 30%, although it has typically been much more when starting valuations were high.
Recessionary periods correspond to periods of high market volatility – rallies and selloff.
Exercise 3. Given the share market’s current positioning and recent performance, using history as a guide, what do you think the coming few months likely have in store for the markets?
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
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The Look-Through
The Look-Through
As humans, we crave to understand things. It’s part of our survival instinct. We don’t cope very well with not understanding something and our minds have a way of spontaneously generating plausible explanations – “jumping to conclusions”. At the point we feel we understand something, our brain releases hormones that make us feel good.
When it comes to investment markets, we’re dealing with money – opportunity to make money and also to lose money. Given this, there’s a really powerful desire to understand. Frustratingly, investment markets are full of irrational things that don’t mesh with our human need to understand.
At any given point, and especially in a market environment like the current one where uncertainty is high, there’s generally a “narrative” – a logical explanation as to why whatever is happening is actually happening. The title for this piece comes from one of the popular narratives at the moment in order to explain things like this chart:
The narrative goes something like this:
“Yes things look terrible at the moment… things are terrible…the global economy is locked down… economic data is woeful … corporate earnings will surely take a huge hit over the coming few quarters…but with light now at the end of the coronavirus tunnel, investors are willing to look through the next 12 months or so to the other side.”
I don’t actually have any great objection with this – how can I? It’s as good a reason as any to explain why share markets are not reflecting today’s reality. But, what I do have major reservations with is the sustainability of this narrative. Oh, and there is another major part of the current narrative – we’ll get to that in a moment.
Today I want to test the current narrative, have a look through history, compare it to now and see whether we can get any sense of what the months ahead may have in store. For a bit of fun, we’ll make this a little bit interactive…
We’ll start with the key bullish argument at present – the “other” major part of the current narrative;
“Don’t fight the Fed!”
I’ve covered “Quantitative Easing” at length multiple times over the past decade however it is so important at present that its worthy of a revisit.
QE is in essence buying bonds. So as a start, who exactly owns US government debt. Here’s a snapshot
Tucked within pensions and monetary authorities are the largest individual holders of debt. The biggest individual holders are in fact US government entities – the Social Security Trust Fund.
With that in mind, why do people invest in US government debt?
For the largest holders the answer is essentially “they have to”. These major investors are under strict investment mandates. And no, the government does not force them to buy their debt in order to create demand so they don’t go bankrupt! It’s simply part of their risk management strategy – managing potential losses and also liquidity.
How about foreign holders? Why do they hold debt? Well, basically for the same reason – the US dollar and debt markets are the only markets deep and liquid enough to park their accumulated reserves. It’s not necessarily because they want to invest in US government debt but they have relatively little choice.
Say you’re a central bank… say China’s… you run a major trade surplus with the world, and with the USA in particular. You are therefore experiencing significant inflows of US dollars. In the simplest sense you need to park these surplus funds somewhere. They are a “financial asset” and need to be held by someone at all times. You can exchange them for other currencies, but it must be an “exchange” – someone needs to have a pile of the other currency you would prefer to hold and be willing to trade.
Convert them into Chinese Yuan? Well yeah, that implicitly has already happened by the businesspeople that brought them in from foreign sales. But the US dollars are not “destroyed” in the exchange – someone has to have exchanged their Yuan for them and now be the proud owner of US dollars.
Through the mechanics of managing their currency, what we’ve seen over the past 20 years is the Chinese central bank has become the holder of many of those US dollars. Again, they can rid themselves of them by exchanging them for another currency. But the numbers are just too large – where else could they park gazillions of US dollars? As I’ve said before, don’t fret about China dumping their US debt holdings. It would be fun to watch them try – it would be a little destabilising to markets but the US will be just fine.
We’re digressing well away from QE here, however, the concepts of “financial asset” and “exchanging” are very important to all this QE stuff.
Now… “Quantitative Easing”. An unconventional monetary policy tool which first appeared during the 2008 financial crisis.
There’s basically two goals with QE. The supposed main goal goes to the heart of monetary policy – setting the “price of money”. Pressure bond prices higher and the effective interest rate reduces. Just like they do all the time as part of their “open market operations” – balancing liquidity in the interbank market so that the effective interest rate reflects their official target interest rate. Perhaps the main difference to normal operations is that central banks are normally just concerned about the short end of the curve – overnight rates in the interbank market. During QE the Fed often targets longer- term rates such as 5 or 10 year bonds.
The second goal is to provide liquidity to debt markets so that they function “normally”.
It’s the pursuit of this second goal that’s raising the eyebrows of many market participants at the moment. The Fed is wading into more markets than ever before such as corporate debt. The question is what’s normal? The US economy has shut down. It’s entirely “normal” that financial assets tied to the US economy will be experiencing a difficult period, just like the economy. But thanks to Fed interventions, some of these markets simply don’t reflect reality. Great. Well done Fed. “Normal” markets.
The Fed can intervene in debt markets and therefore truly manipulate prices. But just in case there’s any confusion, the Fed cannot and does not buy equities or any equities derivatives such as ETF’s and futures.
There seems to be some excitement that the Fed might start to buy equities at some point. It is illegal under their current governing rules, but sadly if the Fed really wants to recklessly pursue a takeover of share markets, I feel there’s a real chance that clueless politicians will be easily convinced that it’s in the nation’s interest to change Fed governing rules. Or given the state of modern politics I regrettably think “selling” a Fed takeover of the stock market to politicians is as simple as saying to them “this will benefit rich people…you are a rich person”.
When it comes to QE, it’s understandable that it’s still quite poorly understood. As an example, I was a little surprised to read some analysis from a veteran commentator that I quite respect where in essence he said:
“The Fed continues to engage in QE, creating more and more reserves in the banking system… because these reserves are not needed some are flowing into equity markets.”
No! There’s several things wrong with this:
Firstly, the “flow” thing. Say I have $1,000 of cash. No, let’s call it $10,000,000. I call up my stockbroker and arrange the purchase of $10,000,000 worth of shares.
Once the transactions settle, how much money has “flowed” into stocks? By how much has “cash on the sidelines” reduced?
I hope your answer is zero… All that’s happened is I’ve swapped my cash for someone else’s shares. “Exchanged” if you will. I have their shares, they have my cash.
The point is that every financial asset in existence needs to be held by someone at all times until it is retired. Every share. Every bond. Every house. Every dollar. Every asset. Money doesn’t flow out of bonds and into stocks. Money doesn’t flow out of “growth shares” and into “value shares”. This concept is very important in the understanding of Quantitative Easing.
Now, let’s explore the transactions involved in “QE”. The central bank wades into the bond market. It buys bonds. It pays for those bonds by “printing money”.
By how much has the private sector “net financial assets” changed in the transaction?
I hope you again answered “zero”. It’s just another asset swap – the central bank now owns the bonds and the private sector has cash instead of bonds.
It’s at this point we really need to focus… There’s a view that all this new money needs to go somewhere and is flowing into the stock market. Let’s examine this carefully.
The central bank buys bonds in the open market. Who are the sellers? Well, whoever they normally are! They are incredibly deep markets – there’s always people wanting to buy and sell for whatever reason. The Fed can’t “force” anyone to sell. (As an aside, this is not 100% true as primary dealers are obligated to trade with the Fed, but that’s not particularly relevant.)
But just for illustrative purposes, say the Fed can force people to sell bonds to them. Say as a private investor you hold $10,000,000 in US government bonds. You get a knock on the door. It’s the Fed – they inform you they are compulsorily acquiring your bonds for the good of the nation. They pay you a fair price… a good price.
Now what? You have a mountain of cash. What do you do? Do you just go and dump it in the share market?
If you answered “yes”, what’s your reason? And why didn’t you sell your bonds previously and buy shares? They are hugely liquid. The Fed didn’t just do you a favour buying them – you could have sold them at any point anyway. Why would you just go and buy shares? The point I’m trying to illustrate that if you think about it this must be the case with every bond holder. If your bonds are exchanged for cash (whether via the Fed or not) you have a decision to make as to what to do with the proceeds. You can choose to put in in the share market (provided of course you are an entity that’s allowed to invest in shares). But it’s an asset allocation decision that comes with risk and reward. For no participant is putting money into shares a “risk free bet”. Nobody.
But it seems to juice markets – how?
There’s no doubt that making money-markets hugely – excessively – liquid is broadly a “positive” – both for those market and the share market. The way in which QE does have a true effect on the share market is via that manipulation of interest rates.
The interest rate on government bonds represents your risk-free benchmark. All asset allocation decisions are (or should be) derived from these rates. Therefore, it’s true that if QE artificially suppresses risk-free yields, it will have the effect of making other risk assets relatively more attractive. But once again, a decision to chase a higher return in the stock market comes with risk for all participants. All participants – nobody is being given free money they can lose without consequence via QE.
We’re obviously dealing with some really hardcore, abstract finance stuff here. I hope I’ve been able to make my points:
QE is merely an asset-swap.
Suppressing yields on other financial instruments can result in other assets looking more attractive.
But investing in shares comes with risk for all participants.
And therefore the view that “QE makes share markets go up” isn’t a fair conclusion.
If holders of shares become “risk averse”, the fear of sustaining capital losses will induce them to sell, no matter how much QE the central bank is doing at the time.
Throughout the brief history of QE, there are clear correlations between central bank balance sheet size and equity indices. But correlation doesn’t necessarily mean causation. My view is that there will come a point in time where the correlation breaks and investors lose faith in the Fed. Given faith in the Fed seems very high, it could be pretty ugly. There’s loads more I could say about QE however there’s other things I really want to address today so let’s move on.
What’s a “recession”?
For those Australians under the age of 35, a “Recession” is basically a period in time when the economy is not going real well. In defining a recession from an economics perspective, most of us are familiar with the “classical” definition of a recession – being two consecutive quarters of negative GDP growth. Economists however have long argued that this is too crude a measure.
In the USA, the entity charged with the task of formally identifying recessions is the National Bureau of Economic Research (NBER), or more specifically, their delightfully-titled “Dating Committee”.
The committee has been around since the 1920’s and is comprised of around nine academic economists – basically a “who’s-who” of the nation’s most respected professors at the time from the most prestigious universities.
The committee maintains a chronology of the US business cycle – a bunch of dates representing peaks and troughs in economic activity. Within this, they define a “recession” as a period between a peak and trough. Here’s a summary of what they look for – straight from their website:
During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year. Similarly, during an expansion, economic activity rises substantially, spreads across the economy, and usually lasts for several years.
In both recessions and expansions, brief reversals in economic activity may occur – a recession may include a short period of expansion followed by further decline; an expansion may include a short period of contraction followed by further growth. The Committee applies its judgment based on the above definitions of recessions and expansions and has no fixed rule to determine whether a contraction is only a short interruption of an expansion, or an expansion is only a short interruption of a contraction. The most recent example of such a judgment that was less than obvious was in 1980-1982, when the Committee determined that the contraction that began in 1981 was not a continuation of the one that began in 1980, but rather a separate full recession.
The Committee does not have a fixed definition of economic activity. It examines and compares the behaviour of various measures of broad activity: real GDP measured on the product and income sides, economy-wide employment, and real income. The Committee also may consider indicators that do not cover the entire economy, such as real sales and the Federal Reserve’s index of industrial production (IP). The Committee’s use of these indicators in conjunction with the broad measures recognizes the issue of double-counting of sectors included in both those indicators and the broad measures. Still, a well-defined peak or trough in real sales or IP might help to determine the overall peak or trough dates, particularly if the economy-wide indicators are in conflict or do not have well-defined peaks or troughs.
Below is a snapshot of recent US recessions together with some other interesting data
If you compare the recession timeframes with quarterly GDP data, you won’t necessarily see GDP contracting all through the “recession”. Indeed, there might be month-over-month improvement in the data through the duration of the recession. This is reflective of the NBER’s explanation of how they define a recession.
I’ve been thinking a lot about the financial outcomes of coronavirus. As I’ve discussed in recent months, there’s little precedent to this event. We already know the US economy is most likely going to enter one of those “technical” recessions (2 consecutive quarters of negative GDP). But judging from history, it will likely linger a lot further than that. Or will it?
What do you think?
Exercise 1: You are a Junior, Probationary, Assistant Portfolio Manager at Aviator Capital. The desk head is leading a brainstorming discussion about the current US economic environment and how things may play out compared with other recessions. He’s asking for everyone’s sense of where, in hindsight, the numbers will be.
Complete the following:
(Month)
Have you got your answers? You are welcome to answer “not applicable – US will avoid recession thanks to the Fed” if you want.
Moving on…
When it comes to longer-duration market movements, we know there is one incredibly important input – valuations. It’s simply common sense – the higher the price you pay for an asset, the lower your prospective returns must be. Said slightly differently, the higher valuation you buy at, the lower your prospective returns.
It therefore follows that comparing where current valuations sit from a historical perspective at any point is incredibly informative.
We know there are all sorts of different valuation models – many of them being quite simple. The most common examples are the good old “Price/Earnings” ratio. And of course many commentators like to rotate between different models depending on which one/s best support the argument they are presently trying to make!
For example, back to our “look-through” narrative. The “current P/E” or “12 month forward P/E” makes shares look very overvalued. “Yes! But on the basis that the economy and corporate earnings will massively recover over the next couple of years… the 2-year forward P/E looks just fine!”
Most of these simple models are pretty useless – with a little data-crunching effort it can be shown they have very limited predictive powers. It’s better we use a model that demonstrably has some serious predictive powers.
And why go to the effort of building something when people smarter than us have already done the hard work. US-based funds manager Dr John Hussman is a prolific datacruncher. He’s tried every conceivable valuation model to test its usefulness and in doing so, identified those models that has proven to have the greatest accuracy.
The green line in the chart below represents “fair value” for the market using a valuation formula that has proven to have a very high correlation with the actual market over the longer-term. The blue line is the S&P 500 index.
The first observation we make is how breathtakingly detached the market presently is from “fair value”. How incredibly overvalued it is. No more banging on about that today – let’s move on.
I’m more interested today in looking at what’s happened to the market in previous recessions. When we compare the chart above to the earlier data on recessions and market drawdowns in recessions, we can make some interesting observations.
I’ve added the yellow bars to mark some of the recessions as identified in the earlier table. The two furthest to the left are the 1953 and 1960 recessions. The bigger one in the middle is the twin recessions of the early ‘80’s. The two on the right are the most recent US recessions being 2001 and 2007. Go back and have a look at the peak to trough fall in the market. Then take a closer look at the chart above.
Notice that most of the time – not always – the market fell less during a recession when valuations were not far from “normal” to begin with. Conversely, notice that the largest falls occurred when the market was significantly overvalued going into the recession.
Oh, and just to clarify, if the market was to tag that green line like it did in 2009 (I stress if as there’s no predictions being made), that corresponds to around 1200 on the S&P 500. Just sayin’…
Those of us who have been through a full cycle or two also have a sense of what the current market environment usually brings. Great uncertainty. It brings volatility as the market gyrates between hope and fear. Central banks can interfere to suppress volatility but as described before they cannot eliminate risk and the natural human emotions that still to a large extent dictate short-term market direction.
How do markets behave in times of recession/uncertainty? Well, here’s a little snapshot of the market during the global financial crisis (thanks again to ClearBridge):
Now, I’m not saying that I think the market will ultimately fall around 60% in the end over a period of 16 months like 2007. But it might.
The market has rallied spectacularly since the march lows. I see commentators now talking about how long it will be till it makes a new high. Maybe it does. But one key point I wish to make is that market rallies – some lasting 30 or 40 or 50 days – are common in recessionary periods. (Be careful with what you might be thinking right now… we need to be counting only “trading days” not calendar days!)
Are the lows in?
Exercise 2: The discussion in the Aviator investment committee meeting has moved on from guesses surrounding the possible length of the US recession to a discussion about the market. Observations are made about prior experiences and how the circa 35% fall in the S&P 500 during March fits with historical precedents. Various valuation models are discussed. Everyone is asked for their guesses. Completing the following:
Nobody knows what the months – the years – ahead hold. As is the case most of the time, history is perhaps our best guide.
The average recession since the ‘50’s has been 10.5 months.
The market has tended to hit its lows around 4 months prior to recession end.
The average market drawdown during the last 11 recessions has been around 30%, although it has typically been much more when starting valuations were high.
Recessionary periods correspond to periods of high market volatility – rallies and selloff.
Exercise 3. Given the share market’s current positioning and recent performance, using history as a guide, what do you think the coming few months likely have in store for the markets?
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