From the President’s Desk: We’re Not in Kansas Anymore

by Donald Gould

We’re Not in Kansas Anymore

The second quarter brought further confirmation that we are facing a very different investment landscape than a year ago. In 2017, the market climbed month after month, with almost no volatility along the way. In contrast, world equity markets took a roller coaster ride in the first half of 2018, yet ended up right about where they began the year. Investor sentiment lately seems to swing between optimism over continued economic and earnings growth on the one hand, and pessimism over a possible trade war and longevity of the current expansion on the other. Over a two-week span in April alone, the US market jumped nearly 5%, but gave it almost all back by the start of May. From that low point, it climbed about 6% into mid-June, only to retreat heading into mid-year.

The sheer volume of important news headlines coming our way daily can seem overwhelming at times. Our counsel is to try to keep an even keel amidst the barrage. Easier said than done, we know, but we are here to help you do just that.

The Wisdom of Crowds…

There’s an interesting book called The Wisdom of Crowds by James Surowiecki, longtime business writer at The New Yorker magazine. It persuasively makes the case that a large group of non-experts (i.e., amateurs or laymen), in aggregate, is far better at estimating than any small group of experts. One simple example Surowiecki gives is a contest at a county fair to guess the weight of a cow. The guesses of the fairgoers are all over the map, but the average of those guesses is extremely accurate and closer to the true weight than the consensus of a few expert cattle farmers whose business it is to know the weight of their livestock. The phenomenon seems to hold across a wide range of fields.

The wisdom of crowds has important implications for thinking about financial markets. Daily we are bombarded by expert opinions (from securities analysts, economists, media pundits, etc.) about the stock market—it’s overvalued, it’s undervalued, it’s going up, it’s going down, etc. But we are probably better off assuming that the crowd—in this case, all investors in aggregate—has a better bead on reality than a few loud experts. In other words, today’s stock price, which is the consensus of the crowd, is probably the best available estimate of what the stock’s value really is. (The corollary to this—regarding stock market direction—is that the crowd always places just a tad more than 50% odds that the next move is up. That edge, however, is far too small to render any short-term market bet a prudent one.)

That’s not to say that the crowd always gets it right; far from it. Rather, it suggests that market behavior gives a better indication of reality than any guru’s analysis, no matter how well informed. The emergence of markets for taking positions on non-financial outcomes (e.g., political elections), now gives us a glimpse into the crowd’s thinking on non-financial matters, too.[1]

…and What They Might Be Saying About a Trade War…

We are asked regularly about President Trump’s seemingly aggressive stance on tariffs. What would a trade war mean for the economy, the stock market, and interest rates? And how likely is it to happen? The honest answer, to both questions, is, we don’t know. But we may be able to infer some answers from the behavior of the markets.

To the first question, we have observed the following. Every time Mr. Trump says he will impose tariffs or other trade restrictions, the market immediately tumbles. From this we conclude that the crowd believes a trade war would indeed be meaningfully damaging for economic activity and corporate earnings. On the second question (the likelihood of a trade war), the market’s view is more ambiguous. President Trump regularly talks tough on a number of issues, including trade, but often reverses course or softens his stance without warning. His own lieutenants regularly send conflicting messages (see, for example, the recent conflict between trade advisor Navarro and Treasury secretary Mnuchin), so the market’s indecision is understandable.

In summary, at this point we conclude that a trade war would be bad news for the economy and stock market, just as conventional economic theory would predict. But it’s much less clear whether things will actually reach that point. We are watching closely.

…and the Odds of Recession

Interest rates continued their climb in the second quarter. Rates on short-term bonds rose faster than on longer bonds, causing a further flattening of the yield curve. A rising and flattening yield curve is the market’s way of sending contrasting views about the short and intermediate term outlooks. In the near term, higher interest rates reflect the Fed’s and the market’s response to a strengthening economy, as well as tight labor markets (low unemployment rates), fiscal stimulus from the recent tax cuts, and consequent inflationary pressures. The Fed has raised its benchmark fed funds rate over the past 2-1/2 years from zero to 2%, with more hikes anticipated.

The prospects a little farther out seem more subdued. Ordinarily, investors demand meaningfully higher interest rates on longer bonds as compensation for locking up their money for an extended period and thereby subjecting themselves to unanticipated inflation and other risks. But as short rates have climbed faster than long, the yield premium offered by long-term bonds over short bonds has shrunk to a 10-year low, meaning the market foresees less money demand in the future than in the present. From this we could infer that the crowd has upped the odds of recession at least a bit. That said, when the next recession begins is still anyone’s guess.[2] The current economic expansion continues to prove more resilient than expected, so watchful waiting is the order of the day.

[1] For example, see www.predictit.org, where people bet real money in real time on the outcomes of political and financial events. As this is written, it places a 41% probability on President Trump being re-elected in 2020.

[2] There’s that old saw about economists having correctly predicted 7 out of the last 4 recessions; it’s a thankless task and one we won’t undertake.

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