Smile, dammit

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Good morning. Summer is over and that’s a drag. But, as I argue below, it is worth bearing in mind that 2023 has gone, and is going, much better than almost anyone expected. And there is reason to hope that the good news continues. Think I’m too optimistic? Email me: [email protected].

Pessimism is sticky

From the WSJ, yesterday:

Stock market bulls are on edge heading into September . . . investors are questioning whether stocks can continue defying expectations and hang on to this year’s gains . . . 

Institutional investors are cashing in on their gains, yanking money from us-focused equity mutual and exchange traded funds for five straight weeks, Refinitiv Lipper data shows . . . 

. . . The jitteriness is turning up in bets against domestic stocks, which reached $989bn last week, up from $886bn at the end of 2022, according to S3 Partners

Any report of investor pessimism has to be viewed with scepticism, especially on Labor Day weekend, the depressing Sunday afternoon of Summer. There are always bears out there, and reporters hard up for stories during a slow week will always get them on the phone. But the Bank of America Global Fund Manager Survey from August (subtitle: “Fearflation”) tells a similar story. It is not just that more managers remain underweight equities than overweight, by a margin of more than 20 per cent, and expect slower growth over the next year by a similar margin. Cash allocations, which had been falling since late 2022, are creeping up again. Commodities are extremely unpopular. There is a lot of glum sentiment out there.

What is striking about the sour mood is the backdrop: a set of events which, just a few months ago, would have been considered the very best-case scenario. The word everyone seemed to use for the August jobs report is “Goldilocks”: jobs and wages growing just slowly enough to keep worries about inflation at bay, while increasing the odds the Federal Reserve does not tighten any further. It followed a July inflation report that was almost as good.

Despite worries about the impact of higher rates and slowing global growth, second-quarter earnings for the S&P 500, while lower than the extraordinary results of a year ago, surprised to the upside (the actual decline was 4 per cent; just two month ago, a decline of 7 per cent was expected, according to FactSet). Profit margins are falling, but gently. Significantly, results for Big Tech companies that have been driving the market met expectations. After months of pundits, Unhedged included, fretting about liquidity problems, the markets are running smoothly: indices of both stock and bond volatility are near their long-term lows. The rise in bond yields seems to be leaving risk assets unharmed. The housing market, a key driver of every cycle, seems to have hit a bottom and, maybe, bounced. While the economic news out of China is bad, government stimulus — in the form of easing mortgage requirements — is starting to dribble out.

What is the reason for the persistent streak of pessimism in the face of positive surprises? Confirmation bias must be playing a role here. Many investors and observers thought the set up for markets and the economy heading into 2023 was just awful. I, for one, was certain that a recession was on the way. Admitting that things are now as good as they look requires that I, and a lot of other people, admit we were badly wrong about something fundamental — the relationship between inflation, rate policy, and growth.

Dario Perkins of TS Lombard captured this neatly in a tweet yesterday, pointing out the recession that Wall Street consensus had placed in late 2023 has simply been pushed forward six months, a shift he called “the most economicsy move ever”. His chart, from Bloomberg data:

I think of this as a general rule of Wall Street: two quarters is the period it will take all predictions to come true (and indeed for all problems to be resolved). Why six months? I suspect because it is a short enough time period not to seem hand-wavy but a long enough time period for the original prediction to be forgotten is necessary.

Of course, one cannot wave away the possibility that the pessimists are right, rather than just stubborn. What arguments can they offer? The most obvious and most popular is also the strongest: that higher rates will have their usual pernicious effect eventually, and the current delay is not that long, by historical standards. The Fed might yet over- or perhaps even under-tighten. There is no answer to the argument, really, other than detailing (once again) the ways in which the pandemic economic cycle is historically atypical. We will simply have to wait and see. To this central argument, addenda about exhausted consumer savings, higher gas prices, European and Chinese weakness, and the relatively high valuations of risk assets can be attached.

Fair enough. The global economy is slowing, and risk assets have had a great run that can’t last for ever. But do not forget to look at what is right in front of your nose: things are pretty good right now. 

One good read

I remember, 15 or 20 years ago, sitting in a meeting with an executive from International Paper. He had been with the company for decades and (he told us with alarming frankness) the company had only earned back its cost of capital in one or two of those years. The paper business is tough even by the standards of commodity industries. There is iffy secular demand trends for many types of paper. There are also idle paper plants near every forest in the world, waiting to be turned on whenever prices rise. IP’s stock has hardly risen over 30 years. Remembering this, I was interested to read Justin Lahart of the WSJ make the case for owning the company. In short, the shares are way down at a moment when inventories of goods that ship in corrugated cardboard have been drawn down, and ecommerce trends remain solid. I don’t know if that’s right, but I love a gutsy contrarian call.