TL;DR at bottom.
Here’s your obligatory bear post for the day/week/whatever.
I’m not an expert but I do have some qualifications that lead me to believe that the global economy is in for some trouble. I could be wrong, of course, and actually my entire theory is predicated on that fact. Still, I feel I am sure enough in my convictions to the point where this statement is worth making. You may disagree with the worthiness of this post, and of course, the premise behind it. That’s fine; I’m just here to share the way I see things.
What’s certain is that, even if one may see the warning signs of a looming crisis, it’s near impossible to tell when that crisis might be. I have no idea. All I know is I see some precariousness and warning signs right now. So, without further ado:
The Uncertain Nature of the World
The world is uncertain. Black swan events happen, and they happen frequently. Again, some people may have some inkling of them, but it’s hard if not impossible to predict these things with any degree of certainty. Some examples that come to mind (please excuse the lack of chronological ordering): the Covid-19 pandemic, September 11th, the Global Financial Crisis, the John F. Kennedy assassination, Columbus discovering America, the Challenger/Colombia space shuttle disasters, the assassination of Franz Ferdinand leading to WW1, the Great Depression, the Black Death, the storm that destroyed the Spanish Armada, the Wehrmacht crossing the Ardennes, the smart phone / internet revolution, etc. The last one is interesting if you ever saw Back to the Future: Pt. 2. The most they predicted were flying cars, but not smart phones or internet.
But I digress. These events are part and parcel of life, and the major events of history do not happen in a linear fashion. Sure, we may be able to connect the dots after the fact, but when they happen it’s almost unbelievable: we seem to be taken utterly by surprise. Just think: apart from Bill Gates or someone like that, which one of us normal folk thought we’d be dealing with a pandemic this time 2 years ago? I certainly didn’t imagine it.
And it happens in our personal lives too. You meet someone. You have a break up. You get injured. You get sick. You lose a loved one. You fall in love. Who knows? Life is very, very unpredictable.
Don’t get me wrong; that doesn’t mean I don’t think we should try. Science helps. We can form hypotheses and test them. This adds a lot of certainty to a world that is very uncertain. But even Einstein would admit that some things are simply out of our grasp:
“What I see in Nature is a magnificent structure that we can comprehend only very imperfectly, and that must fill a thinking person with a feeling of humility.”
The Folly of Economics
I studied economics. I was very interested in Econ 101 and decided to make that my major. Later, however, I was disappointed in what I learned. I don’t know. There was just too much mathematical formulating and analysis. I didn’t feel, really, that I had learned much of anything that was actually relevant and applicable to the real world. To be honest, at the time I just thought I was an idiot and bad at math, blaming myself rather than the field (as a young, lost kid might be prone to do). Looking back, however, I think there were serious shortcomings that I had picked up on but did not have the tools to express.
I’m not saying that there isn’t a place for that sort of analysis in the study of economics: I imagine there is. I just don’t think that it should be the singular focus of the whole field. Indeed, while mathematical equations are imperative for pure math and even for practical applications like physics and chemistry, can they really be applied with the same rigorous veracity to the study of something so complex and changeable as the economy?
Former economic advisor at the Bank of International Settlements William White argues that instead of looking at the economy through equations and equilibria, we should be viewing the economy as a complex adaptive system. You know, like a garden. You have an idea in mind of what you want to plant and where, but some plants die, some don’t, weeds pop up, there might be an infestation. The whole thing is quite unpredictable because it depends on an enormous amount of variables interacting with each other. Well, that’s a lot like the economy. (Read more here: Recognizing the Economy as a Complex, Adaptive System: Implications for Central Banks)
The Folly of Modern Central Banking
The folly here follows naturally from the aforementioned ontological error in the field of economics: we think the economy is predictable and controlable. Cut interest rates here, buy assets there, and we’re good to go. If only it were that simple.
Look at the data we’re looking at right now. Despite absolutely unprecedented amounts of liquidity being pumped by the Federal Reserve (and by other central banks around the world), we’re still unable to get people back to work. Check out the ADP numbers today: 653,000 new positions were expected in July, but the actual result was a miss by just over half (330,000). If you’ve been paying attention to the data in past months as well, you’ve noticed consistent misses in employment. And how about inflation? YoY inflation hikes are expected due to base effects from the pandemic last year, but MoM inflation has been coming in consistently higher than expected. All of this makes you wonder: does the Fed really have things under control? Could they have things under control?
I would argue that you can’t solve structural employment issues by throwing liquidity at the markets. The problem is not liquidity, there’s plenty of it: the problem is structural mismatches, as well as other factors like people preferring to take extended unemployment rather than working. You can’t fix that with more liquidity. One of the most respected modern economists, Paul Krugman, would probably say “well, it can’t hurt”. And according to their models, it can’t. Unfortunately economists and central bankers seem to do be doing their absolute best to turn a blind eye to obvious asset bubbles. SPX is up nearly 48% since pandemic lows less than 18 months ago, while the Nasdaq is up nearly 58% in the same period. Meanwhile the real economy has been absolutely hammered. The Shiller PE ratio is at 38.25 at time of writing – a level unseen since prior to the bursting of the dot-com bubble. It is clear that there is a severe disconnect between fundamentals and asset prices due to excessive liquidity in the system.
If the Fed manages a controlled walk down of interest rates, and earnings continue to grow into current valuations, then no problem, right? Right. It’s possible. But that would be hoping for the best. William White argues that it’s more rational to prepare for the worst rather than naively hoping for the best. A long series of things would have to go according to plan for this bubble to be “defused”, and any number of unforeseen events could arise in order to knock the whole plan off track. Some examples come to mind (and these are just the ones that we can fathom… the whole point is that there are more that we probably can’t): Delta variant or other Covid-related scares, geopolitical tensions with China/USA/Taiwan, inflation running hotter than expected, etc.
And speaking of inflation, why in the world is the Federal Reserve so confident that inflation is transitory? As I mentioned above, YoY and MoM inflation expectations have come in consistently higher than expectations over the course of the last few months, oftentimes to the tune of 70-80%. If whoever is making these predictions is getting it so wrong in regards to the numbers, who’s to say that they aren’t getting it wrong in regards to it being transitory?
Look, it very well may be: the supply chain disruption argument is a valid and strong one. But nobody has a crystal ball. The Fed is not an all-seeing eye where they can simply predict exactly what is going to happen. One might hope that the Fed would be more prudent and humble in their analysis of the situation.
And certainly the Fed has a long history of getting things wrong. In early 2007 Ben Bernanke famously declared that subprime was “contained”. Just a few months later, when the crisis did begin to arise, Jim Cramer called out Bernanke for “being an academic” and for being out of touch with the situation on the ground. Look, I don’t really like Cramer, but I do believe he was in the right at this particular moment. This sub won’t allow me to link it here, but I recommend looking up “Cramer tells Bernanke to wake up” on YouTube. It’s worth a watch.
Let’s not forget either that even before these two events the Fed absolutely failed to anticipate the crisis in the first place. Later they would say that such a crisis was unpredictable, and totally based on panic. But they forget the fact that people like Dr. Michael Burry, of Big Short book and film fame, did see it coming. All of the people in that book saw it coming. Even William White saw it coming, and warned Alan Greenspan of it at Jackson Hole in 2003. The Fed, however, did not see it coming. Bernanke would also claim that the crisis was nothing more than old-fashioned financial panic, and that if not for the panic it would have been the equivalent of merely “a bad day in the stock market”. This is a convenient view for him to take, as it alleviates him of all responsibility for completely bungling the situation. Even Paul Krugman challenges Bernanke’s assertion that it was all related to financial panic and not at all tied to fundamentals in the housing market.
Of course, Bernanke and those around him would hold on to their view that nobody could have seen the crisis coming, and go on to congratulate themselves for rescuing the country and the world from a crisis that they themselves had failed to prevent.
Where We Are Today
And that brings us to where we are today, with massive monetary stimulus coming from the Fed and all major central banks as a response to the Covid-19 crisis. The response to 2008 was seen, rightfully in many ways, as a success. By injecting liquidity into markets when they needed it most, the Fed and other central banks were able to stave off the next Great Depression. Unfortunately, however, apart from their failure to prevent the crisis in the first place, central banks have also failed to take into account the limitations of their policies. Not only have their policies become less effective, but they’ve also opened the door for a dangerous array of unintended consequences (William White talks about both issues here). William White also says that, contrary to what the Fed seems to believe, monetary policy “is no free lunch”.
Recovery since 2008 has been asymmetric: we seem to be trying to fix deep, structural problems via simple injections of liquidity. Meanwhile, inequality grows, the poor get poorer, and political and social unrest continue to grow as a result. It’s a dangerous path to go down, and rather than try to explain it myself, I would recommend reading the White paper I linked above. One clear and present danger I see today, which White mentioned in the paper, is the presence of serial bubbles: the dot-com bubble led to the housing bubble, and the housing bubble has led to the current stock market bubble, only to be aggravated by the Covid crisis and the Fed’s response to it (ironically causing a new bubble in the housing market as well). If something unforeseen were to happen, these bubbles could pop, causing lasting damage to Main Street.
Another issue I see now is that, if we were to have another crisis, what more could be done? How much higher can the Fed expand their balance sheet? How much more deficit spending can the federal government engage in? I believe that we are dangerously close to exhausting our policy options.
If everything goes according to plan, it’s possible that everything works out just fine. The issue, however, may be in assuming that everything will go according to plan.
What To Do as an Investor
I’m not an expert at this, but I would not tell anyone to go cash right now. I would say, however, that it may be wise to hold a larger cash percentage than you’re normally accustomed to. If you normally hold 5% in your portfolio, for example, then maybe you’d consider holding 10-15%. This will provide for buying opportunities in the event that we do have a major correction, and it will also help to preserve capital. That said, full cash does not seem to be the way to go. If you’re waiting for a crash, you may be waiting forever.
What I would recommend, and this seems pertinent to a lot of what I see on this subreddit, is diversification. I see people with dangerous allocations into overvalued tech stocks (“buy Microsoft at any valuation”), holding 3-4 tech stocks as their whole portfolio, a 2-fund portfolio with levered funds UPRO and TQQQ, etc. I see people holding large allocations of ARK funds and other “disruptive” tech with unproven track records. I see people recommending lump sums right now, because, “on average”, they do better.
If it were me, I would diversify and play it more conservatively. VOO would be infinitely better than UPRO, for example. A diversified portfolio of blue-chips which very well may (and should) include stocks like Microsoft would be infinitely better than only holding Microsoft. Patient dollar cost averaging would probably be wiser than dumping one’s life savings into an S+P 500 index fund at the moment.
I would also encourage people to look at fundamentals. One should never, IMO, feel the urge to pay for a stock at 30, 35, or 50+ times earnings just because of “future growth potential”. It’s a gamble.
In the end, all of these strategies that I am opposed to may end up working out and may even end up doing better than my conservative approach. The problem, however, is what happens if they don’t.
TL;DR, Summary, and Final Thoughts
As humans we seem to have a problem with humility. In some ways I think it’s painful for us to accept our limitations and fragility. Thus, it’s easier for us to pretend that the world is predictable, orderly, and within our control. This fallacy has made it’s way into the field of economics and by extension into central banks and the Federal Reserve. Current policies, encouraged by the “success” of 2008, operate under the fallacy that the economy is orderly and able to be controlled with surgical precision, rather than accepting the unpredictability of the economy as a complex adaptive system and taking measures to be prepared for black swan events which will inevitably occur.
As a society and as investors, we can certainly hope for the best, and sometimes the best does manifest itself, and in those cases such optimism does tend to lead to better outcomes for those who profess it. However, perhaps a more prudent, realistic approach would be to prepare for the worst, or at the very least recognize our limitations and put measures in place in order to mitigate the damage which can be caused by unforeseen disruptive events.
Good luck and best wishes to all.