Investors often look to the past to explain the present and the future. Patterns from history can actually provide insight, but they can also lead to false assumptions, says investment strategist Rob Almeida of asset manager MFS in his Strategist’s Corner ‘Averages do not tell the whole story’.
In bear markets, there is often a correlation between historical price declines and the resulting expectations for future returns. A common example: recessions last on average ‘w’ days and stocks fall on average ‘x’% followed by a recovery of ‘y’% in ‘z’ days. Market commentators use these formulas to reassure their customers and suggest that better times are coming. But while they may be right, Almeida argues, it remains a dangerous frame of reference. The waiting time sometimes takes a long time and can lead to significant financial losses.
The problem of averages
The problem is that historical comparisons always assume averages; calculations are made with the middle value of a data series, but the variation box is missing. Example: two cities both have an average annual temperature of 21˚C, but if one city is in a temperate climate with a stable temperature and the other has significant seasonal impact, this average does not say much. More data is needed.
Apart from the problem of simplified averages – as with the cities above – at least in prices, every financial crisis and every recession is different. Even if the historical averages of market declines are provided with pages filled with data, would that help? Almeida does not mean.
A cycle in the economy or market does not die of old age, but ends when excesses are corrected by a financial crisis or recession. This often painful process causes bubbles to burst. The length of this cycle is irrelevant. More important is the extent of the excesses in the market and the extent of the rebalancing process – which determines how far the declines go.
To get an idea of where the excesses of the past lie, simply look at which companies were the most popular on Wall Street at the time. In the 1990s, these were dotcom companies that used the internet as a revenue model. In the first decade of this century, it was the financial parties who were looking for improved returns without additional risks. Wall Street sold them mortgage-backed securities: repackaged loans given to U.S. homeowners who could not (or would not) meet their obligations.
The time it took to recover from the internet bubble and the financial crisis is not related to the next recession. Different imbalances require different corrective processes. How far the S&P 500 fell does not say much. What matters today is whether the economy and the financial markets have resolved the excesses since the last recession.
The current excesses
The answer to the low growth and deflationary risks of the past decade has been quantitative easing. Central bankers believed that cheap borrowing would lead to more economic activity. But that did not happen because there was a fear that economic growth would remain weak if money fell in value. The money went instead to dividend payments and stock repurchases. Quantitative easing turned out to be the problem disguised as the solution.
The financial crisis was followed by the weakest economic cycle in more than a hundred years, but companies achieved their highest profit margins in 2018, again surpassed in 2022 by the waning effects of an overstimulated global economy.
Margins and profits ultimately determine the prices of stocks and bonds. “The S&P 500 has its worst start to the year since 1970” is a dramatic headline, but it misses the point. What is going to drive future returns is profit. Companies are now telling investors that they can maintain record-high margins even if the money stimulus subsides and despite growing fears of a recession and rising costs. However, we are skeptical about that.