Jeremy Strickler
jeremy@wwmgreenville.com

There are a lot of market opinionators opinionating that the economy is better than the market and that the market has likely “priced in” most of the actual impact of inflation, rising interest rates and the War in Ukraine. While that’s a nice sentiment lending a veneer of rationality to randomness, nearly 25 years of doing this job have taught me, that’s not how it works.

Investments don’t just come in to the “right price.” They usually overshoot.

The market, in any given time frame, almost never gives you the average return, and it’s almost always either too expensive or too cheap. The  “average return” is a composite of a lot of price swings. Prices oscillate around the trend.

Knowing the trend—the nature of how things are changing—is a more relevant perception than prices on a given day. Life is lived in at least 4 dimensions, the changing shapes of things, moving through time. It’s a 3D movie, with mass, not a polaroid. (Shake it, shake it) This is also why legalistic thinking– corporate, religious, constitutional, relational legalism– can’t properly account for reality. These concepts turns organisms into Objects and calcify processes into Things. Remember Lot’s wife. You can try to gain security by looking back, but life is lived in forward motion, often by leaving useless things behind.

What’s knowable are the longer trends. What’s not rational, is trying to generate one pricing rationale when “markets” are made up of people, doing different things for different reasons. Not all those reasons are rational pricing of the long term trends. Sometimes, people have to sell assets they don’t want to sell to raise money and pay down debt. That’s what happens in a credit contraction.

In my opinion, a few things need to play out before we get back to a fun market that goes up more than it goes down. And we are not there yet, even though quite a lot of securities are trading at attractive prices relative to their growth potential and relative to the long term growth potential of the US economy. I expect to see 4 stages of this process play out. How long it takes, I don’t know. But you can expect some things to happen along the way:

Signpost 1:  Selloff in the highest risk assets like emerging market tech stocks and crypto. Check. That happened in January and is still happening.

(Between stages, bear market rallies that allow you to sell assets and reposition.)

Signpost 2: Credit spreads widen. This basically means that bonds issued by companies with not great credit should start to trade relatively cheaper than high quality bonds that have interest rate sensitivity but also not much risk of default.

Here’s a chart from Koyfin (a free quote system, you can have it too!).

Let me interpret this for you. To this point, the markets have been more concerned about inflation and rising interest rates than they are about economic problems. And, until now, that’s been the information. We still have strong job growth. So far, the market in risk assets has been worse than the economic data.

However, we may be at a turning point (with first quarter GDP down 1.4%) where the focus in this quarter will shift away from the risk of high inflation to the risk that growth will slow or even that the economy will go into recession. I think in that case you would expect “High Yield Corp”  (lower credit quality corporate bonds) to underperform high quality assets like US treasury bonds.

If that starts to happen, (perhaps we’re in stages 2 and 3 now)

Signpost 3:  Selloff in quality stocks (and maybe bonds) where market participants become forced sellers, and there are more sellers than buyers.  This means that while a number of people might like to think longer term about investments, they can’t. They have to come up with money to pay down credit lines and reduce borrowing costs. Some businesses go out of business.

In this stage, higher quality stocks also sell off, and the number of stocks setting new 52 week lows should increase. We should also have a few “90% down days,” where almost all stocks are down in a trading session, even if some of those companies stand to profit from changing conditions.

So, if you see blue chip Tech, Utilities, Defense and Energy stocks down, it’s not because they’re bad investments but because a good bit of people who own stocks have to come up with cash. 

And with interest rates now 60%-70% higher, real estate, which moves a good bit slower than securitized assets like stocks and bonds, can start to slow or roll over. This can have some reflexive impact on spending, creating a near term feedback loop, where falling asset prices reduce consumption, which hurts earnings outlooks, and asset prices fall further.

Signpost 4:  Poor Economic data comes in, (because that information lags price changes) and through this process, you might see corporations turn from hiring to layoffs. It just depends on longer term economic outlook and whether companies need to cut costs relative to their view of the revenue opportunity.

But the market loves it when corporations cut expenses(!) and labor has been a huge inflationary cost. After companies cut expenses to the bone, when revenues start to grow again, profits increase.

So, in this phase, economic data is worse, but the market opportunity is better. If we start to see the market trade a little lower, but the number of stocks setting 52 week lows actually slows down ( a process where 200 companies set new lows, and then only 100 and then only a few), the energy to sell assets is drying up and it’s perhaps a sneaky good market where people feel terrible about investments but the opportunities are great.

Why do I say we are not through the process? There is still an awful lot of misallocated capital. The past two years gave us gambling on meme stocks and investments in Dodgey crypto assets that are unlikely to hold long term value. The market raised money in undefined terms though SPAC’s (Special Acquisition vehicles) which didn’t explain how the money would be invested.  There are a lot of con men hawking crappy products and get rich quick schemes, and (let us hope) the political nonsense came to a crescendo. Politics is a market.  

Here’s the thing about nonsense, propaganda and corruption: people use falsehoods to gain short term advantage, but processes that are inherently unproductive aren’t self-sustaining. They borrow creative energy, burn out, and do damage on the way. This credit contraction should blow out a lot of misallocated capital, freeing it for truer and more useful purposes. When the tide goes out, you see who’s swimming naked.  And the market takes their fun money away.

I for one am a big fan of seeing nincompoops tarred and feathered and rode out of town on a rail.

(Pennsylvania Whiskey Rebellion Print)

If we literally still did this, we’d spare ourselves some suffering. However, the truth in ideas and markets is like gravity, an inexorable force of nature. The numbers catch up, and what’s real tends to win in the end. That’s why our cultural bargain with free speech is correct. It’s harder to sustain nonsense than to speak the truth, even though there will always be con men and cowards.  

Will this process take a few months, or the balance of the year? I have no idea, and it really doesn’t matter. It matters to have some sense of where we are in the process. Until the fed changes their language and we go back to some neutral or expansionist monetary policy, things aren’t going to work like you want. That’s fine. Be patient.  This can be a great market for Investors, not for short term trading. It’s what we pay for assets when we buy them that determines the future returns.

In the meantime, if you have enough cash to pay your bills, you can afford to wait a year or two for the trends to change. Pay attention to your real life. We got this.