Dear Clients & Friends,
This Weekend’s Reading is likely to be the most important of this calendar year. Below, I will formally outline my forecast for a recession, or at least a steep market correction of at least 20%, possibly as much as 50%, in late 2018/early 2019. Please don’t read this while waiting in line at the supermarket. This article deserves undisturbed attention, so please take the time to read carefully.
Before I go any further, I beg that this message not evoke fear from anyone. Not only will we be prepared, but market drops can be a very lucrative opportunity for investors who are experienced, or guided well, and who have a good handle on their emotions. Has not the most significant attribute to Warren Buffet’s success been buying good investments at low prices?
To set the tone of this message, allow me to reiterate three of my favorite quotes regarding the art of investing…
“You make most of your money during bear markets, you just don’t realize it at the time.”
-Shelby Davis, diplomat, legendary investor and founder of the Davis Investment Discipline.
“Individuals who cannot master their emotions are ill-suited to profit from the investment process.”
-Benjamin Graham, “Father” of value investing
“Be fearful when others are greedy, be greedy when others are fearful.”
-Warren Buffett, Chairman, Berkshire Hathaway
This last quote is of significant importance because a large part of our reasoning stems from irrational exuberance with respect to the public’s current economic expectations.
Lastly, before we dive in: get excited, not scared. This article is intended to give foresight into what we expect and what steps we plan to take. Additionally, we’ll explore what risks are present if we’re wrong and do not experience a recession/correction, and how we intend to profit from the experience if we are correct.
Ok, let’s get into it…
Frequency of Recessions
First, let’s begin by looking at one very broad statistic. In America, we’ve not gone more than 10 years without a recession since 1802. The first US panic since the signing of the Declaration of Independence was the “Panic of 1785.” It lasted three years and effectively ended the business expansion that followed the American Revolution. Part of the issue was a lack of credit, an unstable currency, and an absence of organized interstate trade. The perception of a fledgling government without the support of British commerce exacerbated the panic that ensued.
This panic ended in 1788, and almost immediately thereafter, we entered into the Copper Panic of 1789. Counterfeiting in copper coins led to a halt in commercial growth, which didn’t resolve until paper money was introduced on a far greater scale.
The next recession was in 1796, which may have been the first “bubble” in US economic history. Land speculation was out of control, and deflation from the Bank of England caused a fear-driven drop in economic activity in the Northern States. While I do enjoy history, the cause and results of these recessions aren’t important. What is important is that recessions used to happen all the time.
In fact, between 1802 and World War II, only twice had there been much more than 5 years between recessions. Following World War II, the time between recessions did expand, likely because of the global leadership role the US undertook, as well as the stability of the nation following the War. However, (and this is really important) we’ve still not made it more than 10 years without a recession in 215 years. To that end, unless we have a recession on or before June 2019, which is 10 years following the official end to the Great Recession, we will have made history with history. Some may say that this is an irrelevant statistic, but I think not. History indeed repeats itself, and even if it serves no other purpose, this statistic illustrates the frequency and commonality of recessions.
Deserving greater attention than recessions in American History are the unique similarities between the current state of our economy and that of the late 1990s. There are a number of metrics that we look at on a regular basis in order to judge the current economic climate, and separately, the investment market climate. Some of these similarities are startling.
As a contrarian, my concern is elevated when everyone else is complacent, and complacency often sets in when much appears to be positive. I’ve written in the past about several emotional and psychological biases us humans often fall victim to. “Projection Bias” is the tendency for people to assume that whatever is happening at any given moment is likely to persist, and often the assumption that the present climate will intensify. During periods of strong markets, many investors may anticipate even greater strength in the future. Expectedly, during periods of turmoil, the same investors may fear worsening losses. This particular subset of projection bias is known as the “Recency Effect,” or “Representativeness,” which over-emphasizes current experience as an indicator of the future. This is expressly why virtually every record of an investment’s past performance disclaims that past performance is not indicative of future results. Projection bias is also among the reasons why private investors often pull out of bad markets unnecessarily, or stay in good markets for too long. Herein lies my concern regarding present complacency.
Let us examine a few metrics that we write about regularly and explore the possible presence of projection bias.
Consumer Confidence is a widely published barometer for the level of confidence that consumers feel about the health of our economy. I emphasize “consumers” because we separately review similar metrics from business owners, traders, insiders, etc. It is important that we consider many variations of economic “confidence” because often the assumptions of the consumer do not correlate to the assumptions of the institutional investor. When the do-it-yourselfer and the institutional asset manager are behaving in opposite manners, it often means that the consumer is acting with projection bias, while the professional is acting from a background of research, experience, and reality.
So…. back to 1999.
Let’s explore a few measures of confidence in the economy as seen in the late 90’s and see if we can correlate those trends to current day. As seen in the graph below, the years leading up to 1999 were very good for the economy as well as for investors. We witnessed a number of disruptive technologies (technology that changes the course of the future, such as the explosive growth of Microsoft and Windows 95, the size and mobility of laptop computers, speed and size of chips, Google). Technology led the bull market of the 90’s, and by early 2000 we witnessed activities dripping with complacency. True story - on one day in late February 2000, both a cab driver and my sister, who at the time was a professional athlete, gave me stock tips with substantial conviction, but which were based on theories which had no validity of any kind. (mind you, my sister is among the smartest and most successful people I’ve ever met, albeit in a completely different field) For entertainment’s sake, Infospace, one of the two stock suggestions given to me that day, was trading near a split adjusted price of $1,300 per share. Today, they’ve changed their name and the stock trades at $21.20, a drop of 98.4%. Projection bias combined with complacency can be, needless to say, a very bad thing.
As we’ve seen, it shouldn’t come as a surprise that Consumer Confidence is often soaring immediately prior to economic deterioration. So let’s take a peek at where we were and where we may be going. The chart below overlays Consumer Confidence since the end of the great recession in 2009 with Consumer Confidence leading to, and extending beyond the bursting of the tech bubble in early 2000.
This picture is certainly worth a thousand words, but within it are two conflicting stories. The similarities between the two lines on the graph are astonishing, and therefore, the urge to predict a coming meltdown is compelling. However, we also see that there was a notable period of time in which confidence was high, but ceased growing. It is during periods like this when markets can continue to soar, and therein lies one of our biggest challenges - how to protect ourselves without sacrificing the opportunity for a ”last gasp” of growth?
The next indicator I’d like to talk about is labor. Indeed, labor and the job market are really the most important aspect of our economy. Without work, we don’t generate income, and without income, we have no money to buy things. In a consumption-based economy, no spending is no good. Over the last few years, I’ve argued that the labor market has been better than many people felt it was. It seemed that people were driven by the shellshock and aftermath of the Great Recession, and were hyper-focused on labor participation claiming that generic employment rates were no longer relevant. Although participation rates dropped and caused drag on the economy, we believed that participation was somewhat misunderstood. While it was a small drag, the labor market and conditions had been steadily improving since 2011, and the investment markets produced commensurate returns.
As of today, unemployment is at a 16 year low of 4.3%, which is .3% from what is considered to be full employment. In addition, we are maintaining the longest stretch of jobless claims below 300k in 47 years. Yes, participation is still slightly elevated, and yes, there continues to be areas of labor disjunction. However, insomuch as nothing is ever perfect, this is damn good! In fact, it’s so compelling that we have all the reason to believe that the investment markets still have the capacity for a last gasp, and that last gasp could be substantial. On the other hand, as we approach and push past full employment, the capacity for more growth evaporates. And it must evaporate because if demand for jobs continues, we would literally run out of people for those jobs, and run-away wage inflation could ensue. This is why developed nations consider full employment to be around 4%. As unemployment diminishes beyond that point, hyperinflation can result.
Back to 1999….
In the next graph, we overlay job growth since the Great Recession with job growth leading up to the crash of 2000. By doing so, we see another alarming historical correlation. However yet again, we also see a period of no growth, but no disaster; and therefore we again see the possibility for a last gasp. Despite the shortness of our labor force evaluation, don’t misjudge the magnitude of the chart below.
Another metric we look at frequently is margin debt because we consider it to be a terrific barometer of complacency. Here is a quick primer on what margin debt actually is… (We at MOR Wealth Management do NOT advocate margin investing for the vast majority of private investors.)
An investor can borrow against the value of their other investments in order to invest more capital without having to deposit more money into their accounts. At the core, it is simply borrowing money to invest, using other investments as collateral. The only difference is that there are no “closing” documents, no credit check; none of the traditional loan-related complexity exists. You simply open a margin eligible investment account, and can then borrow up to the federal limit which is ordinarily around 100% of the underlying investment value. So if you had $1,000,000 in a margin account, you could invest $2,000,000 worth of securities.
The reason for margin investing is straight forward. If one can borrow at 4% and earn 10% on the investment, the 6% difference is profit to the investor. Hence the reason that aggressive investors may use margin, especially when they perceive the markets to be “hot." Consider the example above. You have $1 million in an account and invest $2 million. If the market returns 10%, your account makes $200,000, or 10% of $2 million. But your personal rate of return is double that. Ignoring margin loan interest for the moment, if you make $200k on the $1 million you deposited, you experience a 20% return. Pay back the loan and keep the $200k. Basically, if you leverage an account 2:1 with a margin loan, your profits are also 2:1.
Let us flip to a down market. If you deposit $1 million and borrow $1 million just as in the example above, but the market declines by 10% instead of grows by 10%, then you lose $200,000. If you lose $200k on your deposits of $1 million, you experience a 20% loss. As one may have expected, if you leverage an account 2:1, your losses are also 2:1 – just as with gains. In this second example, let’s add the margin interest to really add fuel to the fire. At 4.25%, the interest on a $1 million loan over the course of a year would have been $42,500, so the real losses are actually $245,000, or 24.5%, instead of 10% which is the percentage that the market dropped. (To reiterate the above disclaimer, we do NOT advocate margin investing here at MORWM for the majority of our clients. It can be very dangerous and we consider it to be an unnecessary risk for most private investors.)
To correlate margin to today’s discussion, let us recognize that margin investing can be a dangerous endeavor, and is often far more lucrative to use when the market is low, not high. Therefore, when the markets are high and we see an increase in margin borrowing among retail investors, some will interpret this as projection bias combined with complacency. It is this combination that we are searching for as a sign of an impending and significant market correction.
So where is margin debt, you ask?
It’s high! In fact, it’s notably higher than it was in 2007, and as high as it was just prior to the 2000 tech bubble implosion.
As scary as this is to us, there is a glaring difference between now and then in that we’ve not seen a spike in margin debt. A spike often signifies irrational exuberance, which can be considered by some to be a warning sign of an imminent inflection, and we do not see that here. So while the level is alarmingly high, we are not ready to call for immediate Armageddon. Again, we still think the “last gasp” is out there.
The last metric we’ll look at before we make any further predictions is market valuation, a metric spoken about endlessly by pundits. P/E ratio (price/earnings) is simply the price of a stock divided by its earnings. That’s all!! If a company’s earnings are low but they have a high stock price (which doesn’t usually make much sense), it will have a high P/E. On the other hand, a company with high earnings and a low stock price, which would signify an undervalued company, would have a low P/E. With this description, it may be apparent that stocks with low P/E ratios are usually more desirable.
In addition to a company’s P/E ratio, we can look at the P/E ratio of the entire market, or of segments of the entire market. We do this simply by aggregating many companies together. For example, a popular market P/E ratio is the “Shiller P/E” of the S&P 500. This is the aggregate price-to-earnings ratio of all 500 stocks that make up the S&P 500 index. Look at the chart below…
As we see, only twice since the Great Depression has this P/E metric been as high as it is today, although it’s not even close to where it was in the late 90’s. But no matter its relative score today, it’s high, and it makes us nervous.
So…. what does this mean?
Folks, I started this article by saying that we do not intend to evoke fear in anyone, because we do not see a sense of urgency yet. However, I’ve probably given you enough reason to assume that we are going to make a prediction for something scary to happen soon. And indeed, we are suggesting a strong possibility of a recession, or a major market correction, to occur between late 2018 and mid-2019.
Our hope is that the history lesson with which we initiated this article will inspire confidence that recessions are a part of life and occur regularly. If we get the flu, we’re not going to quit our job, sell our house, burn all of our clothes, say our last goodbyes, and call a hearse. Rather, we will slow down, get lots of rest, stay at our job, perhaps move some things in our schedules around, deal with it, and wait it out. And if concern is warranted beforehand, we may avoid others who are already sick and maybe wash our hands a bit more often, etc, etc. Sound familiar? Prepare, be cautious, make appropriate changes, and stay disciplined- not a bad analogy. We could also take two weeks off of work if one single co-workers gets the flu, but that would probably be an overreaction, and may result in missing a good opportunity at work for a silly reason- another good analogy. I’m hoping you see where I’m leading this conversation.
So… what now?
First, we mustn’t overreact. Private investors have a predicable tendency to overact, and to do so in a hyperbolic way. Second, we must acknowledge that, while I would love to be right about everything, I am not and I could be wrong. If we overreact and I am wrong, we will miss the opportunity for further growth. Third, if I am 100% correct in my predictions, then prior to any recession, we could see another 5%-10%+ in market growth before a substantial drawdown, and we don’t want to miss out on that either. So the key is not picking which theory to rely on exclusively. The key is balance: balance in our approach, in our expectations, and most of all, balance in our hearts when discipline becomes the antagonist. Let’s break down these three elements.
In terms of approach, first we have to realize that scientifically, losing $1 is more impactful than earning $1. If you lose $1, first you must make that dollar back before making further headway. Consider a portfolio which is expected to earn 5% for 10 years straight for a compounding total of 63%. If you lose 5% in the first year instead of gaining it, you need to average almost 6.5% for the rest of the decade to end up where you thought you’d be after 10 years. While 6.5% doesn’t sound much different than 5%, it’s actually 30% higher! You would need to earn 30% more on average over the next 9 years just because of what you lost in the first year. That is a sickening mathematical reality and is precisely why we prioritize safety above all else.
Let’s go to the other extreme and pretend that we dump our investments and go to cash for two years. It’s not as bad, but it’s still not good. Using the same example above, we assume 5% annual return for 10 years, but we earn zero in the first year. Starting in year two, we then have to earn 5.6% on average, which is more than a 10% increase in necessary returns to achieve our goal. So, as much as we want to be safe, we have to master our emotions, because pulling out the market completely is not a worthy solution either.
Speaking about the importance of discipline, we’ve all heard that market timing is a bad idea. In the words of Peter Lynch, a world famous investor and former money manager for the Fidelity Magellan fund: “Far more money has been lost trying to anticipate market corrections than has been lost in corrections themselves.” This was also the fundamental basis for research conducted to determine why investors often achieve notably worse performance than the funds in which they invest in. The research concluded that investors buy and sell in and out of their investment portfolios too often, and the common misjudgment of these investors caused them to buy high and sell low instead of the opposite. Peter Lynch concluded that, during his tenure with the Fidelity Magellan Fund, investors within his fund earned only about half the returns they would have earned had they simply stayed the course through good times and bad.
Consider the effect of missing only a few of the best days over a 20-year period as seen below.
Now this is obviously cherry-picked data. Only an owner of a time machine could actually know when the very best or worst 10 days would be over the course of 20 years. Nonetheless, the math is jaw-dropping and illustrates as clearly as possible why breaking discipline can be a devastating mistake in the world of long-term investing.
I should point out that market timing is not the same thing as adjusting our portfolios accordingly. We may choose to reduce risk without pulling out of the market. We may choose to move some risky assets to safer assets so that we can maintain yield, but steer clear of a train wreck. We may choose to purchase investments which will still grow in a good market, albeit slightly less, but may have lower downside risk. For example, might it be a good idea to turn to an equity alternative that only earns 80% of the upside, but only captures 40% of the downside? Could this be a way to stay invested but take some of the heat off? The answer is maybe, depending on the composition of one’s portfolio, their long-term financial plans, and their risk tolerance. If your investment portfolio is a byproduct of your long-term financial plan and your risk profile is appropriate, never should your portfolio perform in such a manner beyond predetermined expectations.
So what have we done and what will we do next?
Many of you know that in the month of March, we took some recent profits off the table and reduced our risk profile slightly. Because we think that further gains in the market will be temporary, if there are meaningful gains from here on out, we will likely be more proactive in taking those profits off the table in an expedient manner. The result, if we do so, would be slightly higher taxes (due to short term gains vs. long term gains), but more permanency for the newest and most recent profits. If the market were to move beyond our expectations, we may take profits and simultaneously move even more of our portfolio to the “risk-off” side. This is all very hypothetical and will depend on what we see in the market, the global economy, the White House, Brexit, interest rates, and the list goes on and on and on.
This next section is the most important part of this article
What we WON’T do is pull out of the market just because it becomes scary, and it is this point that I’d like to discuss before we close out this weekend reading. The illustration below shows why people can do severe damage by succumbing to fear and ignoring a discipline agreed to before the noise and drama occurred.
Consider once again a portfolio expected to generate 5% per year. Let us further assume that this is a pure income-generating portfolio, meaning that all of the profits come from dividends and interest while the value of the asset, as long as it doesn’t default, is not really a concern. Like a real estate investment, it is the rental income that provides the profit in the short term. The actual value of the property on a short-term basis is, to some extent, irrelevant.
|Income||Growth||Rolling Net Return|
In this example, the investment did not do well in years 1 and 2. Its net return, the income and depreciation together, was negative. But from a practical perspective, the income that was needed was earned, and as long as the investment wasn’t sold, long-term discipline provided the time and patience to see the property value return. All the while, the income never ceased.
Let’s look at the undisciplined investor, who is worried after year one, and gives up after year two…
|Income||Growth||Rolling Net Return|
This investor not only cut off his/her source of income, but they also sold the investment at an unnecessary loss - a double whammy.
The point here is that prudence dictates patience and the knowledge or guidance to maintain discipline, as long as we can stay clear of assets that could actually default. If we are indeed patient and careful, not only are we better off, but we could possibly profit from the fear that is driving everyone else out. While everyone else is throwing out the baby with the bathwater, a disciplined investor will sort through that water and search for the babies. If you’ve ever wanted to know why institutions usually make more money than retail investors, it’s not because they do better during good times, it is because they are more disciplined during bad times.
The last topic I want to mention contains two more emotional biases. We discussed “Projection Bias,” which is the tendency for people to assume that whatever is happening at any given moment is likely to persist, or even get worse. It is the reason why private investors often unnecessarily pull out of bad markets, or stay in good markets for too long. Watching all of your friends pull out of the market would be very hard to ignore. This is known as “Herding Bias,” the comfort that people take in following the herd. Like other social animals, humans instinctively follow the behaviors and opinions of the majority to feel safer and to avoid conflict. In fact, studies show that the brain actually secretes a chemical in the prefrontal cortex that causes pain if you are forced to go against the crowd. So now you are painfully watching your account decrease in value, and all of your friends are bailing from the markets. What are you to do?
The final straw in the midst of destruction is “Action Bias,” which is probably the least discussed and the most obvious. If we feel like things aren’t going our way, we take action, any action, as if action is the antidote for anxiety. These three biases together create an almost certain departure from one’s investment discipline when things are looking bad.
There is a simple solution to action bias in our MORWM microcosm. Always consider the research and our stress tests of each and every client’s financial plan to be the “action.” Whether or not to sell something is merely a reaction to our research and planning. As such, always know that we take action every single day, regardless of whether we are in good markets, bad markets, boring markets, sideways markets, yellow markets, purple markets with subtle pink stripes, etc. We ask all of you to allow us to take whatever proactive or reactive measures are necessary, especially if we believe no reaction is warranted. The action of research and the decision-making that drives the composition and adjustments to your portfolio is what matters most.
So, that’s pretty much where we are. For the sake of summarizing:
1) We believe that we have not yet hit the high of this late-stage bull market.
2) We believe that, during or before mid-2019, the market will begin a downturn rendering its value substantially lower than it is today, and we believe that there is the possibility that a recession will cause such a correction.
3) Please don’t freak out. We are paid to worry for you, and we do it well. Discipline is everything.
And lastly, always remember this, no matter the topic at hand: If there were never any bumps in the road, you’d never enjoy a smooth ride.
Thank you for taking the time to read this entire message. If you’ve made it to the bottom, tell me what 123 x 456 is, and we’ll send you a brand new MOR Wealth Management baseball cap. : ) They are extremely high quality and great for golf and tennis.
Have a lovely weekend!
Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC
1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 |
601 21st Street, Suite 300
Vero Beach, FL 32960
The majority of this content was written and distributed MOR Wealth Management, all rights reserved. Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered through CES Insurance Agency.