The guest commentary was written by Michael Aroesty’s at DBR & CO, a Pittsburgh-based wealth management firm. This piece does not necessarily reflect the opinion of Hedgeye. You can follow DBR & CO on Twitter here.
“I wish we could see into the future sometimes. That’s the problem, isn’t it? I mean, life, it only makes sense when you look at it backwards. Too bad we gotta live it forwards.”
- Richard Lacey, 13 Conversations About One Thing
Twenty years after its debut, 13 Conversations About One Thing remains the best movie you have never seen. The independent movie grossed just $3 million at the worldwide box office, but included notable actors Alan Arkin, John Turturro, Amy Irving, and fan favorite, Matthew McConaughey.
The plot, like a Malcolm Gladwell book, knits several seemingly independent storylines that collide into a powerful and poignant conclusion – the disparate protagonists’ chase for the same elusive object, happiness.
Happiness is the subject of every conversation: the search for happiness, the envy of happiness, the loss of happiness, or the guilt of undeserved happiness. Each storyline connects strangers who find the answers to their problems, ironically, in the questions raised by another. As we close the books on the first half of 2022, many asset classes we track are in bear markets by the common definition.
The carnage has been widespread, from traditional asset classes such as stocks and bonds to alternative asset classes like Venture Capital and Cryptocurrencies. The dynamic environment leaves investors searching for a historical corollary – the stagflationary 1970’s, the bond rout of 1994, the technology bubble of 2000-2002, and the Great Financial Crisis of 2008 have all been referenced. But as Mark Twain never said (the quote has been incorrectly attributed to him for almost 130 years), “History never repeats itself, but it does rhyme.” As far as economic cycles are concerned, there is nothing different this time.
As for the events that drive cycles, it is different every time. Cycles: The Where’s and How’s Identifying where we sit in the current market cycle is the best indicator of what is to come.
The price action in the markets have made it quite clear where investors think we are. As a firm, we have experienced several significant bear market cycles, but before digging into “where” we think we are, it is helpful to reflect on “how” cycles play out.
As a master of cycles, Howard Marks, who literally wrote the book on the subject, Mastering the Market Cycle: Getting the Odds on Your Side, states: “When investors turn highly bullish, they tend to conclude that (a) everything’s going to go up forever (b) regardless of what they pay for an asset, someone else will come along to buy it from them for more (the “greater-fool” theory).
Because of the high level of optimism: Stock prices rise faster than company profits, soaring well above fair value (excess to the upside). Eventually conditions in the investment environment disappoint, and/or the folly of the elevated prices becomes clear, and they fall back toward fair value (correction to the downside) and then through it.
The price declines generate further pessimism, and investors assume things will never get better (excess to the downside). Resultant buying on the part of bargain-hunters causes the depressed prices to recover toward fair value (correction to the upside).
Because of the high level of optimism: Specifically for stocks, while the S&P 500 has returned over 10% a year on average since 1957, the index itself has spent very little time at the average. Just 7% of the time has the S&P 500’s annual return landed within 3% of the historical average – hence the sine curve of cycles.
We saw several classic excesses to the upside in 2020- 2021. Bitcoin, NFT’s, “meme” stocks, and Special Purpose Acquisition Companies (SPACs), and the corrections thereof, all exhibit Marks’ textbook price cyclicality.
After historic gains in 2020 and 2021, each asset is now down some 60% from the highs. In contextualizing our current cycle and using Marks’ framework, this likely puts us between bullet points two and three.
As to where we go from here, though, all conversations lead to one thing: Inflation.
