We decided to sit this one out. The way the market just whipped around over the last few weeks with little provocation, our concern was about informationless volatility, and we did not want to jump into the fray with comments much less action without any additional insight. In our view, there was very little if any new information that came into the market to trigger the bout of vol. A lot of observers and pundits were pointing to data about jobs (or was it wage growth, or perhaps it was GDP?) that signaled the potential for inflation, and with it the specter of a Fed getting the knives out to cut back the easy money. But, at least from our perch, these new data points were not only knowable, they were known, and they were not new. Perhaps rate watchers and equity market participants were hoping if they clenched their eyes very tightly the hallmarks of an expanding economy might go away on their own.
In terms of purchasing power, there has not been real wage growth for at least a couple decades for the cherished middle class, much less their undercompensated neighbors further down the economic ladder. Even at sub-5% unemployment, the quality of jobs may be poor in terms of wages and ability to exploit workers’ educations, skills and capabilities, and many of those workers would take more hours if only they were available. Compounding that, a significant and growing portion of the workforce is self-employed, and not by choice. Many jobs that used to be salaried and permanent, including knowledge economy jobs that were supposed to be the future of employment, have become temporary 1099 gigs if they have not been shipped overseas entirely. When looking at the fundamental reality on the ground, we could not find a rational explanation for why markets choked on encouraging but fairly benign data. An overheating economy appears still far off in the future and the Fed’s path to higher rates is inexorable, yes, but also slow and deliberate.
So what happened?
We, like many market observers, have discussed and written at length about how market movements have become unmoored from fundamentals, that easy central bank policy may be distorting markets, and that the measurable value of security selection has ebbed with the rising tide of passive and formula-driven investing. We have also examined structural issues such as the effect of ETF, derivative, and high frequency trading. But, this latest round of turbulence may have laid bare a more fundamental reality that could explain a lot but provide little comfort. Using the S&P500 as a proxy for the market, the price peak in late January 2018 before this bout of volatility was nearly twice the peak before the Financial Crisis took out the market in 2008. That multiple is around 4X if taken off of the pre-TARP trough. Is the economy two times the size it was in Q4 of 2007? Are wages?
A lot of the liquidity that was infused from the central banks went into the markets, not the real economy. Companies retained enormous amounts of cash on their balance sheets, and in some cases returned cash to shareholders directly or through share buybacks or spent it on acquisitions. That cash did not go into building factories or R&D, and as already discussed certainly did not go into wages. Therefore, it only had a path to the real economy by way of investors who would take their largesse and consume with it. The market expanded more than the economy did, and so we find ourselves living the reality that anything that could affect the money supply has an outsized effect on a market that has risen four-fold feeding on it. It therefore really was not that big a surprise that the market reacted the way it did to the idea that a very small improvement in the real economy could translate to the Fed closing the bar tab.
But, why was everything correlated to the downside? It was very difficult to find anything resembling a fundamental investment (stocks, bonds, commodities, precious metals) that did not go down in sympathy. Diversification did not matter. And here is the insight into the conversations that took place at WCM. We asked the question of where everyone went to step away from falling prices. The conclusion was this – in this market, nowhere. Our view is that the market has become a binary trade for liquid investors. In or out. There are strong cases to be made for how to invest across markets and our current tactical asset allocation reflects that. But in the face of fear, cash was king.
The next question is why we held tight instead of taking action in a sell-all market. The answer is the same. Because the market is binary. And while cash may serve as a temporary defensive crouch, it is not a long-term investment. A liquid investor is not going to take that cash and go buy the corner grocery store or laundromat. Bank deposit rates are still effectively zero. The reality is that the only place for that money is back in the market. Given that there was no actual data that changed market conditions from mid-January to late-January, we felt the market would find the floor and get its legs back. Investor capital would return. That is not to say that we will see equities keep legging up on such a steep trajectory with no volatility as we observed in January, and the prospect for bonds is dimming with rates set to increase (slowly). But, many of the structural problems over the last decade that could have, and maybe even should have, taken the market out, are behind us. Looking ahead, there are clouds on the horizon like rising health and long-term care costs, student debt, and auto debt. Unaddressed, any or all of those could have a Financial Crisis-scale or bigger effect, but not now. Yes, a misstep by one or more of the central banks could send things into a tailspin, and that is where we would see that binary behavior drive a bigger outrush of investment capital that would take much longer to reverse. The market gave Chairman Powell an ugly reception on taking his seat a few weeks ago. Let us all hope it conducts itself with more decorum for the rest of his term.