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Linnard Financial Management & Planning, Inc.
Fee-Only Financial Planning and Investment Advisor
LFM&P publishes Outlook & Trends, a quarterly newsletter. Outlook & Trends provides a commentary on current economic and market conditions as well as a financial planning topic of interest. These past issues provide an interesting view of the progression of economic and market conditions since 2002.
Mark Twain is said to have written, "History never repeats itself, but it does often rhyme". Winston Churchill remarked, “Those that fail to learn from history are doomed to repeat it.” Warren Buffet observed, “What we learn from history is that people don't learn from history.” This issue of Outlook & Trends will attempt to put the current markets in a historical context, so that we can be prepared to learn from history and not repeat it. How closely will it rhyme this time?
Both the economy and financial markets are reacting to a mixture of forces, some of which are visible and others are not. As the effects of Federal Reserve policy lag the policy implementation, the Fed continues to be careful but is starting to think that their actions may be enough to gradually slow inflation. The markets however, as always, suffer from hyperactivity disorder and react quickly to every economic data point and nuance in the Fed’s commentary.
Neither avoiding nor encountering a recession is a sure thing. The Conference Board's Leading Economic Indicators has fallen for 22 straight months. The restrictive financial condition, where short-term rates are higher than long-term rates (an inverted yield curve), is still in place. This anomaly has always led to a recession from this level, so there is by no means an all-clear signal on the economic front. The market seems to be rallying on the expectation of returning to the good old days of low rates and Fed supported economic growth, but there may be an inconsistency here. The only reason that the Fed would lower rates at the speed envisioned by the markets would be due to a recession. Recessions limit economic growth as well as stock market gains. Otherwise, if rates were cut aggressively and economic growth continued, inflation could become an issue again, and the Fed would need to restart the rate increases.
Where did the recession go? Many pundits are looking at the continued strong economy and suggest that we may have avoided the contraction that follows the bursting of a bubble economy. Others are less sanguine. Who will be right?
During 2021, stock market followers suggested that the future would be wonderful and stock prices would advance forever. In 2022, opinions reversed and recession predictions were commonplace. In 2023 the recession worries faded into the background, and predictions of a soft-landing or no recession at all gained traction as we witnessed continuing economic growth and an Artificial Intelligence driven market rally. The fact that a recession has not occurred on the presumed schedule does not necessarily mean that the risk has evaporated however. It may just be a question of when.
The market trend has reached a point where it is technically difficult to distinguish between a bear market rally, a bull market continuation, or the establishment of a broad trading range. The difference in this case may be one of semantics. According to the leading economic indicators, there is very likely a recession in our future. Equities generally do not fare well in recessions, so it may not be important whether this is a bear market rally. a new bull that is likely to be limited by a recession, or a double-dip bear. As long as the Fed keeps its foot on the brake (and somewhat beyond) history suggests that stock returns are likely to be underwhelming.
Artificial Intelligence (AI) is the latest theme to capture the attention of stock market participants. AI is not magic. It is simply a computerized process that typically is trained to recognize patterns in written language, sounds, and images that have been expressed in bits and bytes. Neural networks (machine learning) are software-coded matrices that are built to remember their internal parameters and adjust them when their generated answers come out wrong.
It has been said that the Federal Reserve will continue to raise interest rates until “something breaks”. Recent bank rescues suggest that some cracks are occurring – the so-called canary in the coal mine. In fact, there may be multiple canaries in multiple coal mines, suggested by the international government intervention for British pension funds, Credit Suisse and Deutsche bank.
For the 12 years before the 2021 policy reversal, the government threw an easy money party - low interest rates, easy credit, and money handouts for everyone. It was a politician’s dream. During that time, the balance between spenders and fiscal conservatives shifted so that virtually all were standing on the same side of the fiscal ship of state. Modern Monetary Theory (MMT – a.k.a. the Magic Money Tree) provided the rational. It posited that the government can print as much money as it would like, as long as it does not become inflationary. Global competition and aging demographics provided a countervailing force, so inflation stayed in check. The canary was singing happily.
Under the surface though, forces were building for a comeuppance. Excessive fiscal and monetary stimulus resulted in what was said to have been the lowest interest rates in 5,000 years, and the accompanying financial leverage fueled the “everything bubble”. It drove high stock and bond market valuations. Real estate followed suit. Newly created cryptocurrencies became reminiscent of the Dutch tulip bulb mania of 1630’s. Eventually the financial inflation found its way into consumer prices. Excess money from pandemic handouts encountered supply restrictions from reductions in pandemic manufacturing. The canary's beak was starting to get itchy.
The theme of our April 2021 Outlook & Trends likened the economic condition at the time to Bob Dylan’s song, “The Times They Are A-Changin”. Now, almost two years later, it has become clear that the economic “Times They Have A-Changed”. As the Fed withdraws its support, the economy and markets are likely to produce slower growth and more volatile investment returns.
Periods of gross overvaluation occurred in 1929, 1969, 2000, and 2021. Is it any coincidence that these periods are one or two generations apart? Human behavior, learning and forgetting occur in cycles. At the bottom of bear markets, after losing their nest eggs, the populace swears never to invest in stocks again. The lesson learned by one generation is not felt with the same intensity by succeeding generations.
The Fed maintained their easy money policy for too long, believing that inflation was either not a problem or would be "transitory" at worst. They are now scrambling to catch up by rapidly increasing the Federal Funds interest rate, which is the basis for all other kinds of interest rates in the economy, coupled with much tough talk...Since the economic effects lag Fed policy for months, the Fed is driving down the economic road in a fog. They know there may be a cliff ahead, but they do not know where they are in relation to it. As a result, typically they continue a monetary tightening policy until something in the economy visibly "breaks".
For the last decade, the Federal Reserve and other central banks maintained an accommodative easy-money policy. Likewise, politicians have been following a spend-as-much-as-possible fiscal policy. All things come to an end eventually. Over the years, Outlook and Trends has suggested that these policies were likely to end in future inflation, and that the gross overvaluation of the financial markets would eventually normalize. That future appears to be now.
The economy continues to boom while the markets suggest a rocky period may be ahead. Forces are combining that will test the resiliency of the long running bull market at some point, as well as the Federal Reserve’s resolve. We see a possible analogy to the story in the film, The Perfect Storm.
Inflation continued its rise during the fourth quarter of 2021, reaching a level not seen in 39 years. It is reasonable to suspect that maybe we are not in a business-as-usual time economically. Perhaps the Federal Reserve’s experimental QE policy that has been followed for the last 10 years has generated sub-surface forces that, while long predicted, are now becoming manifest.
How can we possibly understand the current economic environment? There are so many competing global influences. There is so much noise. Does raising the debt ceiling matter? Does the deficit matter? What about inflation? What is Evergrande anyway? Is there any consistency between these issues? Should I care?
There is a psychological concept called “recency bias”, which, according to Wikipedia, is a cognitive bias that gives "greater importance to the most recent event". If it is summer and the weather is hot, recency bias leads one, quite rightly, to pay more attention to their air conditioner than their furnace. This bias is especially strong if the observer has no direct experience or acquired knowledge that would challenge the assumption. Without other contradicting information, it could be imagined that summer will go on forever and a furnace is useless.
Recency creates momentum in the investment markets as investors observe trends and expect them to continue. There may not be any reason for making an investment other than the expectation that a position will be able to be sold at a higher price later to someone else (also known as the “greater fool theory”). This can continue indefinitely until there are no more greater fools, at which time the momentum shifts, prices fall, and recency suggests the fall will last forever.
The adoption of Modern Monetary Theory provides cover for current support policies by explaining that the government can spend as much as it likes by borrowing until a time when inflation becomes a problem. In a short-term sense, this is true. If you are a government, it makes complete sense to drive interest rates to zero and refinance your accumulated debt. As long as rates stay low, borrowing costs also remain low. With close to zero interest, in essence the borrowed money is free. Who can argue with that?.
As it turns out, however, there are many arguments. In addition to free money promoting moral hazard, and risky or useless investment projects that are eventually prone to fail, what will happen at the end of the free period when inflation and interest rates are no longer zero and the extensive debt needs to be repaid? It won’t be possible to rollover, let alone reduce the debt burden without incurring big interest expenses. What might the solution be? 1) Jack up inflation to repay the debt with money that has less value, 2) Raise taxes. As the old saying goes, there is no free lunch. Today’s spending and money printing is borrowing (or perhaps more accurately, stealing) from the future. The policies to avoid the political pain of an economic slowdown today are likely to be paid by future generations.
Last year was a year of rapid change. Rapid changes cause stress, particularly those for which we are not prepared. As time passes, we learn to cope and our situation normalizes. We see opportunities in the new paradigm as it is revealed to us. Slow incremental change is perhaps less stressful, for we have time to adjust. It may be more insidious though, because it can seem more natural and may go unnoticed, like the fable of the frog that does not jump out of the pot of water that is slowly heated to boiling. While it is difficult to prepare for the unexpected, we should endeavor to be aware of slowly evolving trends that can eventually cause great change while masquerading as “this is the way it has always been”.
Have we dodged the proverbial bullet? Or should we be preparing physically, mentally, medically and financially for a Covid counterattack reinforced by the flu? Most people have at least partially adjusted to the virus war that has been raging around us on multiple fronts, being fought by the invisible air force. Hopefully the answer is “yes”, we have learned much, but it is always good to be prepared. However, we should not be so focused on the preparation to be mired in the problems, worries and dangers that Covid presents. Without question, this experience has changed our lives, but then life is always changing.
On the other hand, where there is difficulty there is also opportunity. The more that we can remain aware and adapt, the more resilient we will become. We can pick the good outcomes that arise and leave the bad behind. Just as the space program of the 1960s generated spin-off advances in technology, the current heavy investment in immunology and medical technology can be expected to provide new applications for years to come. The benefits of a broader application of communications technology have the potential to change our lives. The rapid acceptance of communications for telecommuting, education and shopping has accelerated personal telecommunications well beyond telephones and video games. Reducing the energy requirements of travel may become a factor in reducing carbon emissions. Who would have thought that Covid might slow the melting of Arctic ice? There will be good things coming from this experience, if we remain open to change.
Bob Dylan once sang, “You don't need a weatherman to know which way the wind blows”. The economic winds are clearly blowing south at the moment. The virus, or more accurately the government lockdown policy reaction, created a mega-slowdown in economic activity, evidenced by quarantines and massive unemployment as businesses shut their doors. It is probably not coincidental that widespread social unrest has occurred simultaneously.
Economic indicators have worsened markedly. There is no question that, at best, the long-predicted recession is upon us. Unemployment is now 13.3%, reflecting 21 million people looking for work. This is about the same number as during the Great Depression, although the rate was a much higher 25% then. Likewise, the current labor force participation rate is at the lowest level since 1974. Economists are predicting that the GDP-measured business activity will have contracted 35% when the results for the second quarter are tallied.
Over the last month, the COVID-19 disease has turned everything on its head. We have changed from complacency to acute awareness of our surroundings, from social beings to suspicion and isolation, from personal interaction to representation by Face Time and Zoom, from expectations of a functioning society to concerns of shortage. It is all due to a microscopic bug, and perhaps even more importantly, our reaction to it.
The value of the stock market fell 34% over four weeks. This was the fastest 30% decline ever seen from a prior peak. Faster than 1929. Faster than 1987, 2000, or 2008. Government backstop policies have arrested that fall, at least for the moment. Adding to the distress, typical diversification strategies also did not help much. Long-term treasury bonds fell 13% over eight days, and corporate investment-grade bonds dropped 21%. Excessive volatility was commonplace. One 9.2% daily gain was more than erased by an 11.63% loss the following day. These movements are more typical of an entire year’s change than a day.
Lawmakers and regulators have been busy proposing and enacting several changes that could be important for your retirement
and your understanding of what you can expect from financial advisors.
Secure Act
Regulation Best Interest
Form CRS
Stand Alone Fee Table
CFP®
Standards
There are probably as many different investing styles as there are investors. All of them work well sometimes, but none of them work well all the time. Since the bottom of the last recession, passive investing in index funds has yielded very good results. This is not unlike the so-called "one-decision growth stock" strategy of the late 1960s. The one decision then was to buy, and theoretically hold forever. This newest incarnation is the passive index strategy, which has been aided for years by supportive central bank policy and automatic 401(k) investing.
All things come to an end at some point. The one-decision approach ended poorly in the early 1970s. There are now people suggesting that the popularity and growth of indexing will be an accelerant in the next bear market, when many of the passive investors want to cash out of their large-cap S&P 500 index and target-date funds....
When economic cycles are strong and have lasted a long time, there is a tendency, called “recency bias”, to think
that these conditions will remain in place well into the future. Over the last 30 to 40 years, extended expansion periods have persisted
due to either government deficit spending or Federal Reserve support or both.
Keynesian economics suggests that governments should be savers during the good times and provide extra money to the
economy in poor times. Unfortunately, politicians have not maintained the fiscal discipline to limit spending during the
expansion phase. The result has been artificially long expansions, which are good for votes, but allow
large economic imbalances to
build, particularly in the financial markets...
Our current situation can be seen within the context of an economic cycle top. Ray Dalio, founder of the world’s largest hedge fund, has published a treatise entitled "A Template for Understanding Big Debt Crises" that discusses the existence of short and long debt (and economic) cycles. The former last 7-10 years. The latter are 75-100 years. The short cycle causes typical economic recessions. The long cycle causes economic depressions when debt gets too far out of hand.
Dalio also produced a short, animated version, which explains how the economy works. You can see it at https://www.youtube.com/watch?v=PHe0bXAIuk0. While Dalio does not specifically mention it, since short cycles are superimposed on top of the long cycle, it is understandable that there could be multiple bubble tops formed by the peaks of the short cycles near a long cycle top. We may be witnessing this as the long cycle rolls over, evidenced by the sequence of dot-coms, the housing bubble, and now the current central bank QE bubble...
A flattening trend is always present during a period of horizontal consolidation and typically can be seen before the onset of an extended decline in prices. Years ago, when we first started studying the stock market, different periods were dubbed corrections, consolidations and bear markets. Corrections occurred when rising prices got ahead of themselves and were brought back to a more reasonable level within an ongoing upward trend. Consolidations happened when an intermediate term (i.e. about 9 months or shorter) cyclical counter-trend slowed a rising trend down, causing the overall direction to become horizontal. A bear market signified a long-term down trend, which was as much a state of mind as it was a market phenomenon. Sellers created falling prices which reduced the collateral value for margin loans. Less collateral forced more selling. Selling created more selling. Eventually the entire over-leveraged financial structure washed out, until there was no one left who wanted or had to sell...
The contents of Outlook & Trends reflects the general opinions of LFM&P and is not intended to provide investment or planning advice. Such advice is only provided by means of individual agreement with LFM&P.
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