Too Much of a Good Thing Can Mean Trouble

Too Much of a Good Thing Can Mean Trouble

“We don’t see things as they are, we see them as we are.”

Anaïs Nin

It was the most glorious meal I’ve ever tasted. It was bursting with flavors and colors and all smells wonderful. It was a very ordinary pizza (i.e., below average Google review) turned brilliant from my having just finished a backpacking trip, where my daily diet consisted mostly of freeze-dried foods with a 300-year shelf life. This pizza experience was blessed by cognitive biases known as recency bias and anchoring bias; we tend to overweight our more recent experiences and anchor our expectations in them, which amplifies our pain and pleasure over what happens (or doesn’t happen) today.

Of course, cognitive biases can cut the other way and become a curse. This is what has happened this year; we recently had a drop in the global stock market that didn’t feel so great, if not painful. In terms of our recent experience leading up to this event, global equities had risen a whopping 1/3 in value from their October bottom. Further, our recent drop in equity prices came on the heels of the longest period of not experiencing a 5% or greater drawdown in the past 20 years. That is, we had the longest period of tranquility we’ve had in about 20 years, when measured by not experiencing a drop of greater than 5%. And on top of this, the gentle price journey was mostly all upward. So, of course, a drop of greater than 5% felt terrible to so many.

The below chart plots our journey thus far in relation to history. The orange line tracks our year-to-date experience in US equity returns, starting exceptionally only to turn to normal in relation to historical returns over the same period since 1928.

It turns out that a 5% drop in equities is actually quite ordinary fare. In fact, the average drop in any given year of the SP500 is about 10%, as reported in the below chart. Our recent 8% drop was just a little shy of a typical annual drop.

Of course, equities don’t typically fall just to make the average. This year’s drop was triggered by some economic reports that spooked investors. Of particular concern was an unemployment report showing that, as of July of this year, we had reached a 4.3% unemployment rate in the US. How bad is this rate? The below graph shows the average monthly unemployment rate since 1948:

The gray rectangles mark periods of recession for the US economy. As can be seen, it is true that when unemployment starts to increase it often leads to a recession, but not always.

For the below graph I changed the figures to the average annual unemployment numbers to smooth the lines and provide a clearer picture of long-run unemployment. I added a red horizontal line to the chart denoting the most recent monthly unemployment rate of 4.3%. I also added a green line at the level of 5.7%, the long-run unemployment average:

An important feature driving this current unemployment figure is an increase in immigration. In particular, about 1/3 of the unemployment increase has come from recent immigrants who are seeking mostly lower-tier jobs. Nonetheless, simple mathematics requires the rate to go up when the numerator of the fraction increases (i.e., as more people are looking for work, regardless of job quality).

Even with this immigration adjustment to unemployment, it is true that our chance of a recession has increased, as high Federal Reserve (i.e., FED ) fund rates have successfully been slowing the US economy. Recall that the chance of a future recession (at some point in time) is roughly 100%, as this is part of the definition of the business cycle. Meanwhile, the unconditional chance of a recession is about 15% per year (i.e., about every six years we experience a recession). Nonetheless, we economists tend to be overly pessimistic. It was once quipped that economists have successfully predicted the past 10 of 5 recessions.

In this spirit, the below image shows how the probability of recession, as given by a broad swatch of economists, has changed over time. Until last Summer, the average economist still believed we had about a 65% chance of a recession over the next 12 months (i.e., the blue line), which did not happen. Goldman Sachs economists were less pessimistic, reaching a peak of about 30% last Summer (red line). Currently they roughly agree with most economists, placing a 25% chance of recession over the next 12 months. Of course, this means that there is also a 75% chance of no recession.

Recession does matter when forecasting future returns after a drop in equity prices. The below graphic tells us that 12 months after a 10% or more drop, US stocks enjoy over a 10% return, if the economy has not fallen into recession. If there is a recession, returns average roughly zero, and some 70% of all years’ returns are at least positive after 12 months from the initial drop in prices.

Another important factor for investment returns not yet discussed is interest rates. As I’ve previously written [see commentary here] this has been a primary driver of many different investments going up and down these past years (some up and some down as rates gyrated). FED funds are likely to finally start falling this September. Over the next 24 months, FED funds will likely drift down even further.

The below time-series shows markets believe we should end up at 3-3.5% FED funds rates two summers from now. Note, however, these are short term rates. It would not surprise me to see 10-year yields drift up to 4.25% by year-end, towards a more normal long-run yield for 10-year rates. These are simply averages.

We often like to talk about States of the World at Omega: we explore the different potential outcomes and prepare for each of the various scenarios. In this spirit, below are estimates for 24-month FED fund rates, as function of a higher inflation state of the world, a faster pace of rate cuts, an average pace of cuts, and aggressive rate cuts in response to if we have a recession:

Under all of these scenarios, in 24 months we could be anywhere from .5% to 4.5% FED funds rates. Naturally, different investments will fare better or worse under each of these states of the world, or outcomes.

What happens to equities when the FED begins to lower interest rates? Again, it depends on whether or not a recession happens. Historically 12 months after the Fed first starts cutting rates, equity returns on average a gain of over 14% or a loss of over 14%, if there is or is not a recession, respectively.

So, it sounds like a lot rides on whether or not we have a recession? Yep. This is why markets got spooked when unemployment recently ticked up. However, some assets can fare fine during a recessionary environment. In fact, some investments fare relatively better during busts than booms. For example, certain private equity and growth equity investments excel in booms, whereas private real estate debt funds and managed futures can fare well in difficult economic environments.

Although we most likely won’t experience a recession over the next 12 or 24 months, we might. The good news is that we know for sure what will happen: we will experience a recession or not in the next 24 months. So it is, we want to make sure we have assets allocated in strategic ways to have some that can fare potentially well in each of these two environments.

And there are always other forces to be worried (or excited) about. For example, we have experienced a tumultuous political season: an assassination attempt of a leading candidate and another leading candidate dropping out to make room for a new one. How will this topsy-turvy election affect things? Of course, it depends on the election outcome, including the composition of Congress. We can add all of these known forces together to try to estimate the net most-likely effect, which is really hard to do, even with supercomputers.

This is why we have instead chosen to take the route of States of the World Wealth Management®, where we define the possible outcomes and plan for those, allowing for both knowns and unknowns and even unknown unknowns. For example, no matter who becomes president, how much interest rates rise or fall, and whether or not we experience a recession these next 24 months (and anything else we don’t know), we do still know for sure, in 24 months equities will be up, down, or flat. There is no other possibility.

This then makes the task manageable with smart resources: let’s make sure we have some different investments that can potentially fare well during all three of these states of the world. Of course, the overall portfolio will still go up and down, but we will have subcomponents that go up and down differently based on the different outcomes. So, this reality coupled with current portfolio cash flow being enjoyed, means that under either outcome, we can still effectively meet our financial goals, which is the ultimate point of the whole process.

In this spirit, we are also exploring opportunities for different states of the world for political outcomes in terms of financial planning strategies. Our current tax law is set to sunset after next year without an act of Congress. And, of course, Congress may do or not do many other things. So, stay tuned!

In the meantime, your homework is to find some things to do to take advantage of cognitive biases. Happily, I head off for a short backpacking trip on the Continental divide next month, and really look forward to when I come back out of the wild for an extraordinary ordinary culinary experience! Similarly, we look forward to hearing about your adventures and non-adventures when we next visit!

About The Author

As Chief Strategist and CIO at Omega, Dylan has the role of overseeing the management of client assets and financial strategies. He works closely with Omega’s advisors to help create client financial strategies based on clients’ own unique needs and goals.