The ‘risk-on’ trade is back in vogue, as less bad economic data alongside investors’ blind faith in central bankers’ ability to implement the necessary policies to prevent unfavourable outcomes, has pushed the major stock market averages upward by as much as ten per cent since early-June. The bulls are back in charge for now, but the antiquated views of the world that underpin their investment strategies, are unlikely to generate superior performance for return-starved clients.
It goes without saying that the recent turnaround in the stock market’s fortunes has seen the traditional long-only bulls applaud themselves for their seemingly prescient views. The song remains the same for this particular breed of investor – stocks are the most appropriate vehicle for long-term investors, and investors should stand firm in the face of sporadic weakness. The ‘buy-and-hold’ mantra persists, even though the major market averages have made no discernible headway in more than thirteen years.
Unfortunately, the continued complacency has seen few if any of the diehard bulls question why the frequent pullbacks during the three-year old cyclical upturn in stock prices, have ranged between ten to twenty per cent – or more than twice the magnitude of the typical correction in the years before the global financial crisis. The oversight could well prove costly, as the reasons behind the equity market’s outsized moves, suggest the secular downturn that began more than twelve years ago, is not over.
The double-digit percentage point moves in stock prices, both upwards and downwards, reflects the equity market’s increased sensitivity to the economy’s underlying momentum. In fact, macroeconomic developments explain more than three-quarters of the stock market’s performance in recent years, much to the frustration of bottom-up investors, who champion the sharp, albeit low-quality, improvement in corporate fundamentals.
The increased importance of macro as an explanatory factor behind the stock market’s fluctuations in recent times stands in sharp contrast to the extended upturns in equity values from the summer of 1949 to the winter of 1968, and from the autumn of 1982 to the spring of 2000. During these periods, cyclical developments were typically overwhelmed by powerful secular forces that allowed for private sector credit expansion, such that bear market declines of more than twenty per cent were few and far between.
The secular bull market that began in the summer of 1949 encountered three recessions during its first eleven years, yet the stock market did not register a cyclical bear market decline on any of these occasions. In fact, equity investors did not endure one single recession-induced decline of more than twenty per cent during this nineteen-year long secular upturn, and suffered the first major setback only when President Kennedy’s took on the steel industry in 1962 over ill-advised price hikes, which triggered a valuation correction that paved the way for further gains.
Similarly, common stock investors did not suffer one single recession-induced bear market during the period that extended from the autumn of 1982 to the spring of 2000; the record-breaking bull market was notable for the fact that the economy spent just eight months or less than four per cent of the time in recession. The only major setback that investors endured during this almost eighteen-year long stretch was a nasty valuation correction in 1987, which was precipitated by a confluence of negative factors.
It is fair to say that the more than three-year old upturn in stock prices that began during the spring of 2009 looks nothing like these former periods, as the major market averages have already suffered several percentage point declines of more than ten per cent, while the macro-driven fluctuations in stock prices are symptomatic of an ongoing secular bear market. Thoughtful investors need to appreciate what lies behind the stock market’s increased economic sensitivity.
Several commentators who have detected this particular feature of the current cyclical upturn typically trace its origin to globalisation, but it is far more likely that the macro-driven market is a function of the regime in which the economy currently resides. Equity investors enjoyed a disinflationary boom from 1982 onwards, as powerful secular tailwinds combined to precipitate a sustained decline in macroeconomic volatility and an improvement in potential future growth, but the so-called ‘Great Moderation’ came to an abrupt end, once the global financial crisis unleashed dangerous deflationary forces.
Common stock investors are now facing a tug-of-war between destructive debt deflation and successful policy-induced reflation with the probability of each moving in sync with the economy’s underlying momentum. Negative macro surprises increase the chances of the former and reduce the probability of the latter, while positive surprises have the opposite effect. It is hardly surprising in this context that seemingly small changes in economic momentum have an outsized impact on market performance.
The risk-on/risk-off trade has characterised stock price behaviour ever since the global financial crisis struck four years ago. The volatility reflects the ongoing tussle between deflation and reflation – ultra-bearish and bullish outcomes respectively. Top-down investing is king for now.
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