Old habits die hard. The most senior folks still active in the investment business started their careers in the late 1960s, forty years after the last financial crisis (the Great Depression) started and thirty years after it ended. Thus, none of us had ever experienced a financial crisis until 2008. It’s not that financial crises are rare or new – as Reinhart and Rogoff have shown,(1) financial crises have been happening for eight hundred years. But they’re new – astonishing, jaw-dropping – to us.
What we have experienced, many times over, is the usual business cycle, the rotation from economic expansions to recessions that is part of the normal operation of a free market economy.(2)
And we know – at least broadly, directionally – how to play these economic cycles in the stock market. As we begin to come out of a recession – that is, as very early economic indicators are beginning to flash green – we begin to build up our risk asset exposures. We continue to add to those exposures as the expansion takes hold and the boom begins. But then we begin to sense that maybe things are a bit overheated. PE ratios have grown well beyond their long-term averages, same with GDP growth. We begin to lighten up on risk assets ahead of what we fear will be an economic recession.
So, just for fun, let’s call the ordinary business cycle the “old-old” economy. That’s the economy we’ve experienced throughout our careers and the economy we understand and know how to play investment-wise. To us, it’s old-old news.
And we’ll call the economy characterized by a financial crisis the “new-old” economy, not because it’s really new – it’s very old – but because it’s new to us.
Once we make this distinction, some interesting concerns arise. For example, since the new-old economy began (the financial crisis), most thoughtful investors have fairly dramatically underperformed. Why? Because they’ve been underweight stocks and most other risk assets. And why were they underweight? Because they were investing like we were in the old-old economy of recessions and expansions.
During five long years – early 2009 through the end of 2013 – investors looked at the economic data and acted on it as though the lights were flashing RECESSION! RECESSION! And why not? From the perspective of the old-old economy, that’s just what it looked like. Unemployment was sky-high and not coming down. Corporations were hoarding cash and families were deleveraging. Investors underweighted risk assets and stayed underweight.
This turned out to be exactly wrong, since the 2009-2013 period proved to be one of the great Bull Markets in US history. We missed much of it because we behaved as though we were living in the old-old economy, when in fact we were living in a new-old economy. And in the Financial Crisis all that mattered was whether or not the Federal Reserve was going to boost stock prices. It turned out that the Fed was in fact determined to boost stock prices– to create the so-called “wealth effect”(3) – and therefore the thing to own, lousy economy or not, was stocks. Don’t fight the Fed. If we’d been experienced new-old economy investors we’d have understood how to navigate the stock market during a financial crisis, but we weren’t and we didn’t.
Which brings us to today. Being sound old-old economy investors we are naturally looking at the economic data and concluding that things are looking pretty darn good.
Sure, employment numbers are sketchy, but everything else is solid. Typical advance evidence of a possible recession (an inverted yield curve, for example(4)) is nowhere in sight. Sound investment policy suggests that we should now be increasing our exposure to stocks, and this is precisely what many thoughtful investors are doing.
But isn’t this also exactly wrong? Remember that we’re not living through a typical old-old economy where the country is moving out of a recession into an expansionary phase. We’re living in the new-old economy of a lingering financial crisis. Yes, GDP growth was 3.2% in 4Q13 and unemployment is down close to the Fed target of 6.5%. In the old-old economy, coming out of a recession, those would be encouraging-but-weakish numbers. But in the new-old economy of a financial crisis those numbers stink.
Why? Because a recession tends to be a short-lived phenomenon. Even weakish growth will put the relatively modest group of unemployed folks back to work fairly quickly. Even weakish corporate spending will soon soak up the smallish backlog of postponed capex.
But a financial crisis is long-lived phenomenon. It would take spectacular growth and spectacular corporate spending to make a dent in the huge backlog of un- and under-employed people and in the huge backlog of corporate spending projects. 3.2% isn’t going to cut it, and remember that full-year GDP growth was a pathetic 1.9% in 2013. It’s as though a gigantic earthquake caused a mountain to fall over onto Interstate 80 and we are digging out from under it with garden spades.
Moreover, the Fed has finally given up on the wealth effect and has begun to taper its bond purchases. AACK! No more support for stock prices, which are now exposed as having no clothes. Traditional PE ratios turned out to be wrong and Shiller PE ratios were right. Maybe stocks were bid way up and now have a long way to fall.
All this should have been obvious to us, if only we’d had more experience with the new-old world of financial crises and less with the old-old world of recessions and expansions. Instead, we low-balled stock allocations for five long years and now we’re piling into stocks at what might be exactly the wrong time. Old-old habits die hard.
(1) This Time Is Different: Eight Centuries of Financial Folly (2011).
(2) The business cycle has nothing to do with free markets per se, and everything to do with human beings’ penchant for cycling between greed and fear.
(3) I’ve argued that in determining to boost stock prices to create the wealth effect the central bankers were not only wrong, but immorally wrong. See my blog post entitled, “Isn’t the Fed’s ‘Wealth Effect’ a Crock?” posted 2/6/13. But for investors, the question shouldn’t have been, “Will the wealth effect strengthen the economy?” (it wouldn’t and didn’t), but “Will the Fed keep up this insanity?” (it would and did).
(4) An inverted yield curve means that yields on longer bonds fall below yields on shorter bonds, an odd situation. Typically, it means that investors in long bonds are willing to settle for lower yields now because they think the economy is likely to worsen.
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