How can we use Economic Data to gauge where we are in this bear market cycle?

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Wednesday 13th of July 2022

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News in the mainstream media on the economy and its direction are almost always behind the curve.

This is largely due to the nature of the data being relied upon to figure out what has been happening in the economy.

The most important data currently used to decide whether or not the economy is growing, by how much, and its direction, are GDP (size of the economy and its change) and unemployment data. These are complex data sets to capture and as such, they take a long time to compile and are often revised up or down many months later.

What’s more, these are backward looking data. They tell us what happened in the past, but do not necessarily work very well as forward looking indicators, data that give us insight into what will happen in the future. For investors, this means shifting investment allocations based on changes in the headline economic data (GDP, unemployment) is a bad strategy. Markets discount the future into prices today, and so most of the time, markets will have already moved before these backward looking headline economic data move.

In recent weeks many market commentators and the financial press have increasingly been talking about the risks of an economic recession in the US and Europe, with many indicating this is likely to happen at some point in 2023. Others have said this is somewhat premature, validating their more optimistic views by saying that the risk of recession is now higher but it remains unlikely. We think both views are too optimistic and are wrong.

Last week, The Federal Reserve Bank of Atalanta’s GDPNow model, which uses recent economic data to update in real-time its forecast for quarterly GDP growth in the US, forecast seasonally adjusted real GDP growth of negative 2.1% for Q2 2022. Remember, the first quarter of 2022 saw negative year-on-year growth in US GDP. If the GDPNow model from the Atlanta Fed is close to being right, then the US will record a second consecutive quarter of negative economic growth.

The technical definition of a recession is at least two consecutive negative quarters of economic growth. Taking this definition and the aforementioned GDP growth forecast as given, this would mean the US economy is already in a technical recession.

The bad news is that this means talk of recession or no recession is too late, we may already be in one. Take a look at financial markets, and with US equity markets down more than 20% so far this year and bond prices having their worst start to a year in decades, market prices appear to have gone some way to pricing this in already. Expect headlines in the mainstream media to catch up with reality in the coming weeks.

The good news here is that, as we have previously predicted on a previous episode, a recession in the US and Europe is likely to be relatively short-lived. There are no major structural issues in the economy to be concerned about, as was the case in 2008 with the global banking crisis. Another good news story here is that a slowing economy should relieve a lot of the pressure on inflation, in fact looking at commodity prices over the past 6 weeks, this is already happening (another example of forward looking data that help us understand the future not the past). Less inflationary pressure makes it more likely central banks ease up on their contractionary policy and may start talking about easing.

Given the stock market’s function of discounting the future into today’s prices, this means that we don’t need to wait for a full blown economic recovery on the other side of a technical recession before stock prices should start to move up and recover from 2022’s bear market.

What we need are ‘green shoots’, evidence of a turning point in forward looking economic data points and evidence that central banks are considering pivoting away from contractionary policy to fight inflation and are moving towards expansionary policy to support the economy.

Dominion Capital Strategies


This is where China comes in as an interesting case study for why forward-looking indicators matter more for investors than backward looking data like GDP or unemployment.

Despite the very negative headlines today about China’s economy, with some prominent investors even calling China ‘uninvestable, we have seen some forward-looking indicators start to move in a positive direction for several months now, a bullish signal for the trajectory of the Chinese economy later in 2022.

We have also heard increasingly positive commentary from the Chinese government and central bank about policy easing, expansionary fiscal and monetary policy to support the economy. These positive inflections in forward looking data points makes us incrementally positive on the outlook for Chinese stocks, despite the backward-looking data (GDP, unemployment) continuing to look bad. Chinese technology stocks have rallied +38% since May, validating to some extent, the point we are making here.

We will be looking for similar characteristics in the data coming out of Europe and the US as a guide to when we can expect their bear markets in stocks to switch into a bull market recovery. We’re not there yet, but it is getting closer.

Sources: Bloomberg, Yahoo Finance, Marketwatch, MSCI. Copyright © 2022 Dominion Capital Strategies, All rights reserved

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Falling Knives & Fallen Angels

News

Monday 5th of July 2022

Market volatility remains elevated ...

With ongoing concerns about inflation and weakness in the economy weighing on market sentiment. For the stock market, this means volatility is likely to continue and (to echo last week’s episode) we probably have not yet seen the lows in this bear market for stocks.

Periods of market churn like we are currently living through typically punish speculators but can greatly reward the patient and long-term minded investor. When prices are falling, all else equal, the investment outlook for all investment opportunities has improved.

However, there is a huge difference between a bad investment opportunity being less bad, because the price has come down, versus a high-quality investment opportunity which is even more attractive now with a lower price.

An example from outside the stock market is probably useful now. Imagine first, an advertisement for a gambling website, or betting store, close to where you may live. One day a new offer is presented with an 80% reduction in the price of placing large bets. All else equal, this is a better offer than before, but this is still a bad investment even after the 80% reduction in price. It’s a bet, plain and simple, it is risky and should be avoided, especially with large sums of one’s savings or investment capital. These are our ‘falling knives’.

Now imagine a high-quality residential property close to where you live. You know it well, it is spacious, in a nice and pleasant area to live and is in high demand. One day this property is on sale for 80% off its previous price. This is an example of a ‘fallen angel’.

Financial markets today are full of both falling knives and fallen angels, with prices of everything coming down, offering investors a wide array of opportunities to ‘buy the dip’ across multiple asset classes and individual stocks.

Some of these are very risky ‘falling knives’, where the lower price on offer does not necessarily mean investors should go anywhere near. Bitcoin and crypto currencies are a good example of this. Bitcoin is down 71% from its highs in 2021, Ethereum, another popular crypto asset, is down 75%. Many speculators argue this makes them better investment opportunities now. We would argue these are falling knives and trying to catch them would be a grave mistake. Any price above zero for cryptos in our view is too high.

Many stocks also exhibit similar characteristics, still trading on very high valuations despite major declines in share price. Tesla stock is down 45% from its highs last year. Compared with cryptos, at least investors own something in the real world with Tesla stock, in this case an electric car manufacturing business, but again, speculators are tempted to start buying Tesla stock at these now lower prices. Again, we caution against catching a falling knife here, as valuation levels still remain eye wateringly high relative to other auto companies and other more reasonably priced assets in the stock market.

Sadly, many retail investors in particular are falling into the trap of putting new money to work in these and other similarly risky assets, buying the dip and adding capital to speculate on prices of over-priced assets.

Price declines alone do not make great investments.

What matters is price relative to underlying value and the cash flows the asset you are buying will generate.

Some asset prices are down and rightly so, they were just too damned high and should be avoided even at much lower prices.

Finding the fallen angels, or at least investing in strategies where this is a stated aim, is where investors should now, we believe, be focusing their energy.

Some of the leading businesses in the world today, in previous market downturns, traded down 50% or more, seeing prices decline along with the rest of the market index at the time. Amazon was down 85% from its peak in the 2001-2002 sell-off. These price declines of our ‘fallen angels’ were accompanied by major declines in the price of the ‘hype stocks’ of the day, which never recovered.

These ‘fallen angels’, when bought at or close to market lows, turned out to be the best investments of the subsequent two decades. Amazon bought in March of 2001 would today have generated a 200-times return (in other words a $10,000 investment would be worth $2 million after 20 years).

The current market turmoil will be creating similar opportunities for the long-term minded investor. 

Sources: Bloomberg, Yahoo Finance, Marketwatch, MSCI. Copyright © 2022 Dominion Capital Strategies, All rights reserved


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«Goldilocks Economy» and the three «Bear markets»

News

Monday 5th of July 2022

Afirmamos que este año (2022) representa un momento excepcional para los mercados financieros…

Last week, we claimed that this year (2022) represents a rare moment in financial markets which typically only occurs once every decade or so. A year where the financial paradigm changes, where the old rules and investment strategies that worked stopped working, and where new approaches will be needed for success in investing. 2008, 2001, 1987, and 1984 are relatively recent examples of these.

These periods of change in financial markets are almost always accompanied by a bear market for stocks. A bear market is a market which trends down for a prolonged period, typically between 3 months and as long as 2 years in some cases. And there are different types of bear market too. Three in fact.

If we are right, and 2022 turns out to be as important as previous moments of market dynamic shift like 2008 and 2001, understanding what type of bear market we are in now is critical to determining how investors should position themselves. It also helps us estimate how long the bear market will last and when we can start thinking about the next bull market.

We think of the three bear market categories as being: (i) structural, (ii) event based, and (iii) periodic.

  1. A structural bear market is one driven by a major structural re-adjustment in the economy. The 2008 bear market was structural, as it was driven by a global collapse in confidence in the banking system following the bankruptcy of Lehmann Brothers. The 1929 crash and subsequent depression is another example.

    Structural bear markets are typically very long in duration, often lasting many years, unsurprising given the structural causes, as these negative factors take a long time to wash out of the system.

  2. Event based bear markets, the second type, are very different. These are the shortest in duration and are caused by, you guessed it, a specific and usually unforeseen event. The 2020 bear market is a classic event based bear market, triggered by the COVID-19 pandemic.

    A highly uncertain and sudden event changes market sentiment and asset prices decline quickly in response. Since these are not driven by major structural problems in the economy, these bear markets often resolve themselves quickly, as weas the case in 2020 with the market rally and strong bull market in the April – December 2020 period.

  3. La tercera categoría de mercados bajistas es la periódica o cíclica. Se trata de mercados bajistas desencadenados por las últimas fases de un ciclo económico y la consiguiente subida de los tipos de interés que se produce en las últimas fases de un mercado alcista. Normalmente, la inflación aumenta, los bancos centrales suben los tipos de interés, el crecimiento se ralentiza y se produce un mercado bajista en los precios de los activos. ¿Le resulta familiar? Debería, ya que esta es la categoría de mercado bajista en la que creemos que nos encontramos actualmente.

What does this mean for investors?

Periodic bear markets typically last between 9 and 18 months and they are not accompanied by major financial crises, so the rally out of these markets is often quite strong, usually in more value-oriented stocks early on, followed by growth stocks later in the rally. The 2001-2002 bear market is a classic example of this. The recession then was mild, there was a bear market, followed by a 7-year bull market in stocks.

If we’re right, we’re currently 6-9 months into this bear market. The bad news is: that probably means there’s going to be a bit more pain in markets before we can start thinking about a sustained recovery in asset prices. The good news is that, well, we’re already 6-9 months into this thing, and that means, based on historical examples at least, we’re probably less than 9 months away from the end of this bear market.

Another positive outcome of this prediction being right is that the subsequent bull market should be a strong one, given the lack of a major structural headwind to the economy. If the last market cycle with these features is anything to go by, the 2023-2030 period would be one of very strong investment returns, particularly for those with a renewed focus in aligning their investment exposure to investments trading on low and reasonable valuations today, that also offer exposure to the major drivers of growth in the global economy during the next bull market.

Before the 2020 pandemic, the 2011-2019 economy and accompanying bull market, was often described as a Goldilocks economy, one where inflation and growth were neither too hot, nor too cold, but ‘just right’ to sustain asset price appreciation and a strong economy.

Investors should not count out the possibility of a return to the ‘Goldilocks economy’ after the current market turmoil passes. The factors that gave us such an economy before the pandemic are still there, under the surface (ageing demographics, new and deflationary technologies), and may reassert themselves. Though we’re not predicting this particular outcome, its realisation would be very bullish for stocks in the long-term. 

Sources: Bloomberg, Yahoo Finance, Marketwatch, MSCI. Copyright © 2022 Dominion Capital Strategies, All rights reserved

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