It’s always interesting to hear from the bear camp during a bull run. Morgan Stanley strategist Andrew Sheets thinks the stock “cycle” is nearing an end, and tells us why.
There’s no shortage of pretzel logic in the investment world, and sadly, this is actually the standard fare in these professions. It takes quite a bit to stand out in this regard, but chief cross-asset strategist Andrew Sheets of investment bank Morgan Stanley deserves special recognition.
Sheets sees the stock market at the end of a cycle, or at least sees signs that tells us that the end is near, in spite of what may be going on in the stock market right now, which we are supposed to ignore. This is supposed to represent reasons to pull back from stocks, which he is advising his clients to do.
In his words, he is “strategically neutral” with stocks, and advises that we maintain more balance until these issues resolve, which is another way of telling us to move assets away from stocks and into other assets such as bonds or precious metals.
There is so much wrong with this reasoning that it’s even hard to know where to start, but we’ll begin by looking at his using the term “cycle” to describe the way that the stock market works, as in stocks move in cycles somehow.
We aren’t entitled to confuse the business cycle with stock cycles. Stocks have followed the business cycles’ ups and downs over history, although there are people who think that stocks have cycles of their own and think that they can just look at stock trends and somehow make predictions about stock cycles independent of what may be going on in the business cycle.
The job of managing business cycles ultimately falls upon the Federal Reserve, and we cannot speak of stock cycles following business cycles without looking at where we may be in the business cycle, which requires that we know a little about how business cycles cycle.
This all has to do with credit markets, and the risk with this is rates of inflation driving up interest rates which lead to contractions in the economy. There are three situations that we find ourselves in, which are expansion, contraction, and stability.
We might think that the most desirable condition would be expansion, but it’s actually the riskiest, because as we expand, inflation rises, which is met with higher interest rates. While the Fed does raise rates in inflationary times, this sort of thing would happen regardless, as if the future value of money is reduced by inflation, lenders will need to charge more to not fall behind, because the future value of the principal repaid is discounted by inflation.
While we might think that all we have to do is match the interest rate hikes with inflation and maintain equilibrium, this is not so easy and we tend to overshoot these targets, and intentionally in fact. Since we want to lower inflation during these times, this requires that we pursue economic contraction as a goal.
When we need to do too much of this, this increases interest costs beyond revenue as well as making it more expensive to borrow to grow your company more, but that’s what we’re hoping for here. We often overdo this and this is how recessions are born. We enter the contraction phase of the business cycle, and while this in itself does not cause stock prices to drop, investors see this and become concerned and sell more than they buy. Stock prices decline in turn.
If the Fed wants to stimulate the business cycle, they lower rates, and this is where we are at right now. We’re both in a low-rate environment and in the stable phase of the business cycle, which is the ideal, and when Fed Chairman Jay Powell told us that we’re in the mid-phase of the cycle instead of late in the phase as some believe, this is what he is talking about.
More appropriately, we could call this the stable phase, and these things aren’t really subject to time constraints but instead to economic ones. We could be taken off this track by things like the Fed raising rates, significant tax increases, trade embargos, or a number of other things, but as long as we remain on this stable track, there is no real reason for concern that the current business cycle will end.
Armchair economists, on the other hand, who are trying to act like economists but aren’t even aware of the fact usually, will tend to look at stock prices and think that there are independent cycles that occur that happen apart from changes in the business cycle, like the view that the stock market simply tires after a long run such as the one that we are currently on.
As long as the stock market itself maintains confidence, and the demand for stocks is maintained, there’s no reason why it would ever collapse unto itself with business conditions remaining positive. Trying to predict stock cycles without looking at the business cycle therefore doesn’t make sense, at least if you are trying to predict a change in direction prior to it occurring.
The stock market does its own predicting though, and we don’t even have to get to the point where we see contraction make it to Main Street very much, as we saw with the risk of the economy being cooled off even more in 2018. Rates were going up, and more of this was promised, which was enough to produce a correction in stocks that year.
These things don’t happen by themselves though, as they are always preceded by some sort of significant change, in this case the Fed rising rates, with the accompanying economic contraction, and finally, the decline in stock prices that this also causes.
We need all of these elements for a cycle change with stocks, and if we have none of them, you wouldn’t think that anyone who is being sensible would worry, but not everyone is as it turns out. Not everyone understands the basics of all this, including Mr. Sheets, although he is certainly not alone.
We Cannot Just Ignore the Facts
What makes Sheets’ sounding the alarm right now stand out so much is that he is telling us to ignore stock performance and just follow his advice in spite of it being so at odds with the facts. If you are worried about a pullback in stocks, it simply does not make sense to act without any real evidence of the phenomenon, which we’ll look at next.
We invest in stocks with an expectation that their prices will rise over time, although there are times when this isn’t happening, and the probability shifts from being more likely to go up to being more likely go down. A lot of investors simply stand pat during stock cycles, even in the face of the worst moves against them, but some do wish to time their positions and look to exit during down cycles of note, bear markets as we call them.
Even if we know for certain that a bull market will end and a bear market will begin, we don’t know when the transition from a positive expectation to a negative expectation will occur, and we don’t just want to guess like Morgan Stanley did last July, telling their clients to pull back from stocks.
Morgan Stanley did pull back from this advice last November, as they apparently came to realize how mistaken this guess was, but this is not something that we ever want to make wild guesses with as they did. We especially do not want to be thinking about these things in such an unstructured way.
There really wasn’t that much to worry about back then even without the Fed cutting rates, but their lowering them was no surprise and the bank should have realized this if they were paying attention at all. There is never a need to guess at these things, because if you are worried about a pullback and it happens, you can act then, when the odds are actually now against you, in a clear enough way, and there’s no need to be proactive here and just guess at these things.
There are times where pulling back and even pulling out is warranted, and it’s actually never the best course of action to just pull back in the face of negative expectations or excessive risk. The pullback in 2018 was one of these situations, where the market gave a big thumbs down to the actions of the Fed at the time, GDP was declining as they intended it to, it cost more for the companies that they own stock in to borrow, and they told us that things were about to get worse.
In cases like this, once again with the odds against long positions in stocks, reducing your positions just doesn’t make sense, no more than it would when you smell smoke and only have half of your family leave the house. Given that we’re told to do this by so many in the best of times, being defensive when there isn’t any need to and harming our returns without any good reason other than foolishness, we should not be surprised that they want us to do this when a full defense is actually needed and appropriate.
If it’s more likely that we will lose than gain, why we would be willing to accept a significant portion of the extra losses that hanging around with a percentage of our money over just avoiding further potential losses altogether isn’t something that is explained, although the fact that there simply isn’t a good reason would explain why.
When we advise that investors time their positions, like Morgan Stanley does, we at least owe it to clients to provide good advice, to pull back when it is actually appropriate to do so. There are two elements that are required for pulling back to be sensible, which is the risk being high enough and the market acting in a way that would suggest that it is high enough to heed.
An excellent example of this was when the coronavirus scare first started to manifest, when we had the risk of this precipitating a significant selloff due to both the potential economic impact of this together with a lot of investors just being skittish and looking for a reason to sell. With both bonds and gold moving up and stocks starting to move in the other direction, moving completely into these other assets was wise enough, even though the market ended up steadying itself and rebounded in short order.
Once the stock market told us that they weren’t too bothered by this and things started to rebound, we gave the all clear to get back in, and this is a good example of tailoring your actions to the climate, where if things had actually turned sour we’d be much better off doing this, but if it was a false alarm, the costs of this insurance would be minor and well worth it.
There are some who held on and wanted to see more, but at a time where the risk was high, this worked out this time but if we just kept going down, we’d end up paying too high a price for our inaction. This is not something that we need to be that fine with, as investors, we are only worried about the significant stuff, not just some minor pullback as the market takes a little rest.
The lesson here though is that we need both the risk and the market confirmation of it, and what stood out with the coronavirus episode is that the risk was considerably higher than the much smaller worries of May and August of last year, but we still need to let the market tell us what it thinks of these things. We can’t ever let our guard down but we don’t want to be relying on wild guesses to decide these things and need to instead look to the evidence and do our best to interpret whether the odds are on our side or not with a potential move.
Sheets’ Reasons for His Position Are Shockingly Bad
To do this without even a move at all happening is in the category of wild guessing, but we need to now turn to what Sheets is basing his guessing on to get inside the mind a little more of one of these guessers.
Sheets is guessing that stocks will decline for the following reasons. In his own words, he tells us that “historically, in the ‘downturn’ phase of our indicator, long-dated bonds outperform stocks. Defensive and large-cap equities outperform cyclicals and small caps. U.S. stocks outperform those in the rest of the world. Investment grade credit returns more than high yield. Precious metals outperform other commodities. All have been happening, not just year-to-date, but for the better part of a year.”
There’s a lot here, so we’ll tackle these beliefs one at a time. For starters, long bonds are not outperforming stocks, so that one is patently false. When bonds outperform stocks, that can only mean one thing, which is that stocks are underperforming. In case some people aren’t aware of how dead wrong he is about this without looking at the numbers, we’ll compare the S&P 500 with the iShares 20+ Treasury ETF, the benchmarks of stocks and long bonds.
Since he did refer to the better part of a year, we’ll look at the 12-month return of both. The bond ETF is up an impressive 18%, which is pretty impressive for bonds, extremely so in fact. The S&P 500 is up 22% over the last year though, and we learned in kindergarten that 22 is not a smaller number than 18.
If we look at more recent results, since late August, we see that the S&P 500 has gained 17% while the value of this long bond ETF has declined by 2%. This isn’t long bonds outperforming stocks even in a good fairy tale, although it can happen in a bad one it seems.
When bonds actually outperform stocks, this can indeed be a good reason to think of moving to bonds, and in fact, provided that bonds are rising in value, it is a very good reason. We need to have it happen first and not just imagine it. This in itself destroys Sheets’ credibility as someone needs to tell him to simply check his numbers and that would be enough to have him choke on that statement.
We now move to his observation that defensive and large cap equities outperform cyclicals and small caps. Small caps have been underperforming large caps for a long time so we can just toss that as this is actually indicative of a strong market. Even in downturns, small caps underperform, so this one is meaningless and foolish.
We’re not sure what the distinction may be between large caps and cyclicals because some large caps are cyclicals, and have to untwist this pretzel logic a bit and assume he means large caps that aren’t cyclical, consumer staples and utilities. Utilities have been doing great, and consumer staples have performed fairly well, but cyclicals have been doing even better.
You might miss this if you just don’t bother looking at the numbers though, and when you think that long bonds are outperforming stocks these days, it’s not hard to see how you could miss this as well, from not even looking. To put this idea to rest, technology stocks are as cyclical as they come, and anyone that is not aware that tech stocks have well outperformed anything else out there just isn’t paying attention at all.
Once again, the risk here is that both types go down and cyclical sectors, especially the tech sector, goes down more. This is indeed a red flag, if it were actually happening that is.
Next, we have the fact that U.S. stocks are outperforming those in the rest of the world, and Sheets at least earns a little thumbs up for at least getting the facts right with this one. This is not indicative of a risk for a turnaround though, and is actually purely bullish if you are invested in U.S. stocks. We have no idea how this could possibly be a negative, and this has been happening for quite a long time now, throughout the entire current bull market in fact, and has not brought anything but good.
You need something to actually change to portend change, and saying that something that has been happening all along will turn the tide is simply ridiculous.
Investment grade credit returning more than high yield credit is also a true statement, but this has only happened because demand for investment grade credit has been so much higher than with junk bonds. The difference here lately has only been very slight in fact, less than a percentage, which has been achieved not due to the lack of performance of high yield bonds, but instead due to so much demand for the investment grade ones.
On each end of the scale, the most investment grade versus the least, the iShares 20+ Treasury ETF has returned 14.83% over the last year, while the iShares High Yield Corporate Bond ETF has returned 14.23%. The red flag here is seeing a lot of defaults with high yield bonds, bringing down their returns, but we’re not seeing that, and a return like that with the high yield ones is simply fabulous in itself. This is clearly a bullish sign for the economy and for stocks in turn, and is another case of a gross misinterpretation of the facts on Sheets’ part.
Finally, we get to his last jab, the fact that precious metals are outperforming other commodities. Precious metals often appreciate in value more due to a flight to safety, when the stock market sells off and then people put more money into the metals. We need the stock market to actually sell off to complete this circuit though, which obviously isn’t happening. Otherwise, the performance of precious metals is not even relevant at all.
There are plenty of flawed ideas out there in the investing world, rife with predictions that are simply baseless, but Sheets may have earned himself first prize in the terrible category with this. We could not even have imagined reasoning this bad from anyone in the investment world, but they say that the truth can be stranger than fiction, and it sure is this time.
Market Review - Eric Baker - 18 February 2020