What Goes Up, Must Come Down

It’s May Day—how appropriate. With the strong sell off in US equities at the end of last week, it certainly feels like the markets are in free fall, causing many investors to scream that quintessential signal of distress, “Mayday!”

And with good reason. US equity markets have turned in their worst 4-month start to a year in more than 50 years. In other words, very few market participants have experienced anything like this kind of market. That is important to remember when digesting market commentary. Much of the investment community looks in the rearview mirror for analogs and clues about future market direction. In fact, quantitative and factor-based investing, so prevalent in today’s market, are based entirely on the premise that the past contains indications of what tomorrow will likely bring. However, when markets are in transition, as they are now, there are so many unknowns it is difficult to form any consensus from past experiences. That is why we are experiencing the kind of volatility that results in “risk-off” behavior.

It feels different this time because, well, it always feels different when the fundamental factors underpinning market performance change. This isn’t the first market with violent swings in equity prices and it isn’t going to be the last. Markets tend to get overextended to the upside when participants get too complacent, and then to the downside when they get overly panicked. That’s what happens, regardless of the root causes.

We should, however, take comfort from the fact that markets are “mean reverting” by nature. What goes up, must come down and vice versa. Over time, markets actually do figure things out, and when they do, they establish a new trend that is upward and to the right. The graph (below) of the S&P 500 index from 1970 to today clearly illustrates this point.

S&P 500: 1970 – Current

There have been some very ugly times when the market was filled with uncertainty, much as it is today. At those times, it felt as if the market would never recover from the current events —such as the 1987 crash. But if you look at the graph, you see that obviously wasn’t the case.

Of course, it can be frustrating and emotional when markets are volatile. That is why it is important to keep a list of factors that you think the markets will eventually digest before resuming their long-term trend.

Here are some of the key factors that I am watching:

Inflation

Inflation is real. Given the amount of fiscal spending coupled with the most accommodative monetary policy in history, inflation is hardly surprising. Don’t get me wrong, much of the early stimulus during Covid was needed to help the global economy keep functioning during lockdowns, but, in my opinion, such policies should have ended a long time ago. The excess liquidity in the markets in Q1’21 was evident even to the most novice market professional. I am amazed that the Fed didn’t begin its tightening process a year ago when the first sparks of inflation were already in the air. However, there was no political will and a real lack of prudent independent thought leadership. But we can’t just blame the Fed. Now that people are experiencing what inflation means to their daily lives, it’s hard to fathom that the US government came so dangerously close to pouring massive fuel on the inflation flames with a huge Build Back Better spending package less than 6 months ago. I find it unimaginable. Every time I hear Congressional leaders saying inflation is a real problem, I recall that they were claiming that the US economy still needed more stimulus at the end of last year.

Fed Tightening

As a result of inflation, the Fed has to be more aggressive with monetary policy than it has been in many decades. However, monetary policy is like a pendulum. When it is moving in one direction with increased momentum it takes a lot of force to get it going in the other direction. It’s actually helpful to look at the past to examine previous Fed tightening cycles and their impact. Every time the Fed has needed to tighten aggressively, it results in a recession. Every time. That is why the market is already pricing in a high probability of a recession even though the Fed has barely begun to tighten. Once the Fed makes its next big move in a few weeks, the market will begin to see how serious they are about dampening inflation and will have a higher degree of certainty about the amount of tightening required, as well as how quickly it will likely happen. The good news here, in my view, is that the market already fears the unknown of the magnitude of tightening required and pace at which it will happen. As a result, it is likely pricing in worst-case scenarios for both inflation and recession. Any clarity from the Fed’s actions will allow the market to better assess both variables—and that will be welcome.

Corporate Operating Margins

Margins in a number of industries are under serious pressure for the first time in a long time. To be fair, they were also under pressure during the early days of the pandemic, but that got resolved pretty quickly. Now it appears as if there are some real structural issues companies need to contend with, and it will take some time for them resolve:

  • Supply chains. Figuring out the new normal for supply chains may very well confound most fundamental investors. Rethinking supply chains has broad implications for capital spending and operating margins for just about every company that has a supply chain. A case in point is the challenge investors appear to be having, given the market reaction last week to Apple’s earnings or Amazon’s earnings. Even automakers have parts shortages that are impacting their forward revenue and expense projections. The entire system of just-in-time inventory management is being called into question. The market is finally coming to grips with the fact that supply chains are going to have to change, especially with the war in Ukraine and the increasingly frosty relationship between the US and China.
  • Wage inflation. Re-shoring supply chains also means moving them into domiciles with more expensive labor. That will also have a longer lasting impact on margins especially if those locations are already experiencing inflation of goods and services which will keep upward pressure on wages.

This one-two punch has a lot of investors and analysts redoing their long range earnings models after Q1’22 earnings with the expectation that corporate profits will be under pressure for a while. That, in turn, leads to lowering of EPS projections for many companies. Markets are simply getting ahead of that new reality by pricing in new earnings with higher discount rates given all of the uncertainty. It is this lack of consensus around long-term earnings models that creates more equity volatility until there is more clarity.

Nonetheless, despite this current uncertainty, we can be assured that the market will eventually figure it all out—because it always does. I have been saying for a while that markets adjust more quickly than ever to economic conditions because of the vast amount of data available to analyze underlying factors, combined with the greater processing power that market participants collectively have at their fingertips to do that analysis. This is why markets rallied well in advance of the post-pandemic economic recovery and why they are falling so quickly in anticipation of the next recession. The wild swings may make it feel like each day in the market is a month, but it is just the market collectively processing what it believes will be the new normal.

It is also important to remember that growth is a derivative of stability and, in times of uncertainty when investors are trying to figure out basic economic and operating models, it is hard for them to focus on growth and disruption. But eventually they will because they always do.

Growth, disruption, and technological change will still be very much a part of the new normal.  At Cowen, we strive to identify and grasp the innovations driving that change and which of those long-term trends remain sustainable. We still have a high degree of conviction that these trends will continue to be dominant investment themes for years to come:  the extension of life and the quality of that life extension (life science innovation and the future of healthcare), carbon neutrality (the importance of ESG investing and the trend towards sustainability in every industry), new tools to help companies drive margins and efficiency (the rapid commercialization of AI and the future of mobility), the new ways that humans are engaging in a post-pandemic world (explosion of the metaverse and web 3.0), and the coming institutional involvement in digital assets, which we believe will ultimately transform our own industry. It is only a matter of time until market participants have the bandwidth to assess their impact once again.

As a side note, I am honored to be attending the 25th annual Milken Institute Global Conference this week in Los Angeles, with the theme of “Celebrating the Power of Connection.” As business leaders and global thinkers gather to discuss important topics, I look forward to listening and learning, and will share what I learn with you.

In the meantime, take a deep breath and buckle up. What’s happening in the markets now can be viewed as not only rational, but also necessary to drive the next leg of upward economic growth.

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