Rorschach-Test Economy Lets You See What You Want
The expansion and bull market are aging and the data no longer point in just one direction.
Bloomberg, October 24, 2019
Where are we in the market cycle? How likely is a recession? How cheap or expensive are equities? What level of return should I expect? And what can investor sentiment tell us about these concerns?
These may be typical investor questions, but the answers are anything but.
The reason is that the post-crisis economy, as well as U.S. equity markets, are at that point in the business cycle where the evidence is fairly balanced, with each data point having a counterpoint.
It is not always this way. There are times when investment sentiment is more uniform. Remember the “mental recession” called out by former U.S. Senator Phil Gramm in 2008? That was nine months into the worst recession in decades, leading to a 57% collapse in equity markets. The crowd got that one exactly right, while economists, many pundits and at least one ex-senator got it precisely wrong.
Other times, it can be the crowd that gets it precisely wrong: Amid a blizzard of warnings, investors plowed capital into money-losing, high-flying dot-coms in 1999 and not long before the inevitable collapse. The wave of selling amid the panicky stock-market lows in March 2009 is another. After that, the shell-shocked herd voiced intense dislike of the huge recovery, which I dubbed the “most hated bull market” ever. 1
But much of the time, we are at neither extreme. Within that full range of the crowd being monolithic and right or monolithic and wrong, is an ambivalent phase where the full spectrum of beliefs is in evidence. The data pretty much support whatever viewpoint you choose to hold. I liken these periods to a Rorschach test, because you can find whatever it is you might be predisposed to see. Bull market? Check! Bear market? Check! Recession, expansion, muddle along, new normal, negative interest rates? Check, check, check!
But let’s indulge in a little exercise and cite a few data points and their opposite:
-Some economic models show recession is inevitable. Others show continued expansion, while others show something in between. Take your pick;
-Standard & Poor’s 500 Index earnings this quarter have been surprising on the upside. Ah, but the strong performers report early. Just wait till the dogs show up;
-U.S. markets have been little changed during the past 18 months. So what? Year-to-date they are up almost 20%;
-Wage gains are ticking higher, making people better off — that is, unless you need health insurance, housing or have to pay for college;
-The housing market has recovered nicely since the bust. Too bad it’s driven by multifamily home and apartment construction, a reflection of the inability of too many young people to afford a single-family home;
-Much of the developed world is mired in negative interest rates amid weak economic growth; but safe, liquid long-dated U.S. Treasuries yield almost 2%;
-The S&P 500 is within a few points of all-time highs amid signs that earnings will be buoyed by the continued U.S. economic expansion; of course, this over-optimism is a huge bear-market signal.
We tend to find these crosscurrents of contradictory evidence when expansions mature and different sectors of the economy throttle back from the higher rates of growth that marked earlier phases of the recovery. It’s the perfect recipe for confusion and ambiguity in the economy and an even greater lack of clarity than usual about what the markets are likely to do next year.
The Rorschach-test economy shows itself in all sorts of markets, economies and political events. Pay close attention to the discussions about WeWork, trade wars, corporate earnings, Brexit, even presidential impeachment. If you do, you will notice that there is little illumination and a lot of confirmation of the speaker’s biases.
I admit, I come to these issues with my own bias, which is only this: Nobody knows anything. The ambiguity we see gives investors and pundits lots of room to put their biases on display. We invest a lot of time and energy constructing a model of the world, and when facts challenge that model our instinct is defend our past decisions, even if they are objectively wrong. This is how we are wired. This, of course, can be problematic for investors.
Which brings us back to the markets and the economy. Rather than asking ourselves what we see in the data, perhaps the better question for investors is why: why is it you see whatever it is you think you see, be it bull or bear, recession or expansion.
That answer is much more illuminating than you might think.
1. In October 2009, I called this “the most hated rally in Wall Street history,” noting:
“Many people — both pros and individuals — all have reasons as to why it must end badly: PPT, hyper-inflation, bad economy, etc. Most bull moves do not end when they are hated, they come to a halt and reverse when they become over-owned and over-loved. We are not there yet.”