The World Usually Doesn't End

I wonder what it is about people who enjoy making dire predictions. A snarky cynic might suggest that doomsday-ers are simply trying to impress upon their audience that they posses special knowledge… that they are aware of something for which no one else is yet prepared. Maybe that’s true of some, but I believe that many who predict darkness around the next corner remember the pain of difficult times they experienced and want to help others avoid it in the future. Regardless, and though occasionally bumpy, the world usually doesn’t end.

One researcher believes that dire talk can have dangerous consequences and is calling out those who engage in it, in a rather pointed way – by showing how much money investors would have forfeited had they acted on their doom and gloom.

The graph below has been making the rounds through the financial press and social media. It comes from JP Morgan’s top investment strategist Michael Cembalest who charted the opportunity cost of switching from stocks to bonds after a so called “Armageddonist” made cautionary statements about markets and/or the economy.

It’s a clever idea and makes for juicy sound bites like “portfolios would be less valuable by 60% if investors listened to the likes of Jeff Gundlach and Nouriel Roubini”… Sure but c’mon, what do you expect? Gundlach is a bond guy and bond guys always see the glass half empty and “Dr. Doom” Roubini is perpetually adorned with a “the end is neigh” board sign.

Levity aside, some important perspective is worth considering. First, it’s a cherry-picked list focused on just those who have sounded the warning bell, not those who have been calling for Dow 50,000 for a decade or more. But that’s OK, I see what he’s getting at.

Second, in fairness to the individuals he lists by name, all the comments (many of them warnings of an impending economic slowdown and recession), were made prior to the Tax Cuts and Jobs Act of 2017, which as a deficit-fueled sugar high almost certainly extended the economic cycle. One might argue that without it, the recession that many on Cembalest’s list were warning against may have come to pass.

Along the same lines, one “Armageddonist,” Simon Johnson, was quoted in October 2016 describing the risk of economic slowdown due to Trump anti-trade policies. Trump hadn’t even been elected at that point, yet we know now (though falling short of sparking a recession) the trade conflict is having a negative impact on the economy.

Third, I like Cembalest’s implied chastising of market timing. He seems to point a thinly-veiled finger at any poor sap who made a market-timing decision and jumped out of stocks into bonds. An important affirmation we can take away from this, for individuals and institutions alike, is that investors should determine the asset allocation that makes sense for them and stick with it, regardless of what anyone says, until personal or market situations change so dramatically that the previous allocation no longer makes sense.

Fourth, there seems to be another implied takeaway from the study. As a reader of his report and an investor, I could be forgiven for thinking that I should never pay heed to anyone who says something other than “the stock market will go straight up forever” and if I ever take my foot off the accelerator in my own portfolio I’ll be sorry. We shouldn’t automatically assume that market participants who operate with a healthy skepticism are always wrong. Cembalest himself concedes that elevated equity valuations, weak leveraged loan underwriting standards and other factors pose potential risk, which is consistent with our fifth and final point:

Expecting the stock market to continue higher unabated into perpetuity is foolhardy. In other, more average stock market environments, a graph like this would probably not exist. I suspect that it won’t start showing up again a few years from now either.

That’s not to say I consider myself among the “Armageddonists.” I have no interest in attempting to predict either a recession or a bear market, but there are a number of undeniable facts that should temper our expectations for future stock market performance.

From January 1928 through September 1981, interest rates ascended but were largely steady until they rose sharply toward the end of that period. Over the course of that time, stocks outpaced inflation by 4.6 percentage points annualized, which seems about normal. In the years that followed through today, as interest rates declined, stocks beat inflation by nearly 9 percentage points annualized. Yes, inflation has been lower but not much, only 2.7% vs. 3.2%. U.S. interest rates could go lower or even negative, but they won’t be dropping from the upper-teens like they did since 1981. In the absence of a declining rate environment, average to below-average stock market performance should be expected.

Combine the absence of falling rates with elevated price/earnings multiples and expectations become even less optimistic. The cyclically adjusted price/earnings multiple, the so-called CAPE or Shiller P/E stands as one of the most effective predictors of long-term stock market performance, yet today is more elevated than just 5% of all readings since the late 1800s. Is that a bear market signal? Absolutely not, but it does force us to recognize that the future will almost certainly not look as rosy as the past.

The successful investors of the future will likely not be so because they predicted the onset of recessions and/or bear markets and avoided them. That’s all but impossible. But neither will success be found among those who expect the stock market of the recent past to persist at the same scalding pace in years to come. What is needed for the future is a realistic current expectation of future stock and bond market returns and a willingness to branch outside traditional, long-only mandates.

Thank you for reading. Please share and/or leave a comment.

Michael