Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 466

Beware the headlines as averages don’t tell the whole story

Historical patterns can provide a useful roadmap for the future but can sometimes lead to mistaken assumptions. People tend to look to the past to make sense of the present and the future. During bear markets, a wildly overused, and I believe, dangerous, frame of reference is historical drawdowns (losses) and their implied assumptions about future market returns.

For example, a widely-used formula goes like this: Recessions last an average of w number of days, and equities fall an average of x% followed by a recovery of y% in z days. Market commentators use formulas such as these to ease clients’ mental anguish and imply that better days are ahead. Better days are ahead. However, they can take longer than experts expect to materialise and may be accompanied by significant financial pain.

The problem with averages

Averages tell us the central or typical value in a data series but provide no window into variation. For example, two cities may share an average annual temperature of 70°F, but if one is in a temperate climate where the temperature is quite steady and the other experiences significant seasonality, the average doesn’t tell you much. More data are needed to decide when to visit one city and when to visit the other.

Apart from the problem with simple averages, every market drawdown, financial crisis and recession is different. Even if historical market drawdown averages were accompanied with pages of data, would that help? I don’t think so.

Recessions wring out excesses

Economic and market cycles don’t die of old age. They end when excesses are corrected due to a financial crisis or a recession. These, often painfully, wring out overinvestment in both the real economy and financial markets. The length of the business cycle is irrelevant. What matters is the level of excess and the magnitude of the needed rebalancing process. That determines how much further we may still have to fall.

To get a sense of where past excesses lay, look no further than to whomever was Wall Street’s favourite client at the time. For example, in the 1990s it was the dot-com companies. The Street’s favourite (and most profitable) clients were companies with a concept leveraged to the internet, seeking capital. In the 2000s, the preferred clientele was financial institutions looking for enhanced yield without excess risk. The Street sold them mortgage-backed securities consisting of repackaged loans made to American homeowners who were unable (or unwilling) to fulfill their obligations. That led to the GFC.

The time required to heal following the internet bubble and housing crisis is unrelated to the next recession. Different imbalances require different corrective processes. The level of the drawdown in the S&P 500 or MSCI EAFE back then is no longer the issue.

What matters today is whether the real economy and financial markets have cleared the excesses built up since the last recession.

Where are today’s excesses?

The policy response to low growth and deflation risks during the 2010s was quantitative easing. Central bankers expected it to lead to capital creation and corporate borrowing to fund productive activities. It didn’t, because money-debasing signaled weak growth prospects to producers. Borrowed money instead went to pay dividends and repurchase stock. Quantitative easing turned out to be the problem masquerading as the solution.

Wall Street’s favourite clients in the post-GFC era were non-bank companies. Financial leverage among that group reached new heights before the pandemic and exceeded those highs once central banks turned the lending spigot back on in April 2020, unlocking credit markets.

As I wrote back in April, despite the weakest economic cycle in over a century, corporate profit margins reached all-time highs in 2018, only to be surpassed in 2022 due to the lagged effects of an over-stimulated world economy. How? Debt is a pull-forward of future capacity, and companies pulled forward an unsustainable amount of margin and profit.

We don't believe corporate margins will be sustained

Margins and profits ultimately drive stock and credit prices. The headline “S&P 500 on track for the worst start of the year since 1970,” is dramatic but misses the point. What will drive future returns is profits.

Currently, many companies are telling investors they can sustain all-time-high post-stimulus margins despite rising fears of recession and a step-function jump in costs (explaining why earnings expectations remain elevated in the face of obvious revenue and input cost pressures), but we don’t believe them.

Risk is usually hidden in plain sight. What do your eyes tell you?

 

Robert M. Almeida is a Global Investment Strategist and Portfolio Manager at MFS Investment Management. This article is for general informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This article is issued in Australia by MFS International Australia Pty Ltd (ABN 68 607 579 537, AFSL 485343), a sponsor of Firstlinks.

For more articles and papers from MFS, please click here.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

 

RELATED ARTICLES

The early signals for August company earnings

Reporting Season will show cost control and pricing power

Collateral damage follows the end of profitless prosperity

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Welcome to Firstlinks Edition 464 with weekend update

The 2021 Census reports that Millennials are now the largest generational group in Australia. While we are increasingly secular and culturally diverse, our differences are far more accepted than the way the US is heading. And please take our short retirement survey.

  • 30 June 2022

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.