PWA 2023 Year-End Letter, Part 5: More On the Current Cycle

"...if we apply some insight regarding cycles, we can increase our bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us." --Marks, Howard

 

What I'll call my broken-record line of the past several months has been:

"While you and I may or may not appreciate the world we'll be living in during the next cycle, it'll be rich with macro investment opportunities, once we're through whatever's left in the current cycle." 

 

So let's break that down:

My implication that there's more to play out before we can declare coast is clear to allocate for the early-cycle phase of what's to come stems from, frankly, 39 years of intimacy with the economy and with global markets.

You see, while of course anything's possible, the economy, and, say, the equity markets, don't typically bottom amid backdrops like today's... In fact, alas, they typically peak amid such conditions.

As for markets, let’s fashion together a checklist... We'll begin with five questions Howard Marks ponders when determining the prevailing stage of the investing cycle:

• Are we close to the beginning of an upswing, or in the late stages?

• If a particular cycle has been rising for a while, has it gone so far that we’re now in dangerous territory?

• Does investors’ behavior suggest they’re being driven by greed or by fear? Do they seem appropriately risk-averse or foolishly risk-tolerant?

• Is the market overheated (and overpriced), or is it frigid (and thus cheap) because of what’s been going on cyclically?

• Taken together, does our current position in the cycle imply that we should emphasize defensiveness or aggressiveness?

Regarding the third question, it should go without saying: 

"...the outlook for returns will be better when investors are depressed and fearful (and thus allow asset prices to fall) and worse when they’re euphoric and greedy (and drive prices upward)."  --Marks, Howard 

And here was John Kenneth Galbraith on why asking such questions is key to managing risk into an ever-uncertain future. Or, in other words, why investors seem to always circle back and make the same mistakes, over and over again:

"When the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world.

There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present."  

We'll answer Marks's questions in a bit, but first let's see if we can define where we are in the economic cycle.

So are we, as the consensus on Wall Street seems to think, embarking on Phase 1? I.e., on a new expansion?

Well, what does that typically look like?

Britannica does a nice job describing each phase:

Phase 1: Expansion. During the expansion phase, interest rates are often on the low side, making it easier for consumers and businesses to borrow money. The demand for consumer goods is growing, and businesses begin ramping up production to meet consumer demand. To increase production, businesses hire more workers or invest capital to expand their physical infrastructure and operations. Generally, corporate profits begin to rise along with stock prices. Gross domestic product (GDP) also begins rising as the economy gets its “boom” cycle underway.

Hmm... So "interest rates are generally on the low side."  

Here's a look at the fed funds rate: 

I guess we won't be checking that box!

"The demand for consumer goods is growing."  

Here's a look at retail sales:

Actually, that metric has improved of late, although the jury's still out. Definitely something to keep our eyes on.

"Businesses begin ramping up production to meet consumer demand."  

Here's a look at industrial production:

And the ISM Manufacturing Index:

And small business optimism:

Definitely no boxes to check there just yet!

"To increase production, businesses hire more workers or invest capital to expand their physical infrastructure and operations."  

Here's a look at non-farm payrolls:

And job openings:

And here's capital goods new orders along with small business capex plans:

"Generally, corporate profits begin to rise along with stock prices." This one we can concede to, although I wouldn't use the words "begin to" when describing the rise in profits. 

Here's a look (yellow = corporate profits, white = SP500 Index):

Suffice to say that the current environment (definitely not Phase 1) perhaps doesn't quite validate Wall Street's present giddiness!

Now, refer back to each of the above charts as you read the characteristics of phases 2-4 (red-shaded areas highlight past recessions).

 Phase 2: Peak. At this stage, the economy reaches a maximum rate of growth. As consumer demand rises, there’s a point at which businesses may no longer be able to ramp up production and supply to match the increasing demand. Some companies may find it necessary to expand production capabilities, which entails more spending or investment. Businesses may also begin experiencing a rise in production costs (including wages), prompting some to transfer these costs over to the consumer via higher prices.

Consequently, businesses may begin to see a “topping-off” in profits despite charging higher prices. Other businesses will see decreasing profits due to higher manufacturing (input) costs or higher wage demands. Overall, inflationary pressures start to build up, or “bubble,” and the economy begins to overheat.

Typically, the Federal Reserve will hike interest rates to combat rising prices—making it more expensive to borrow money—in an attempt to cool the economy.

Phase 3: Contraction. Then the economic contraction begins. In this stage, corporate profits and consumer spending, particularly on discretionary (e.g., luxury) items, begins to fall. Stock values also decline as investors move their investments to “safer” assets such as Treasury bonds and other fixed-income assets, plus good ole cash. GDP contracts due to the decrease in spending. Production slows to match falling demand. Employment and income can also decline as businesses temporarily freeze hiring or resort to laying off workers. Overall, economic activity slows, stocks enter a bear market, and a recession typically follows.

Sometimes a recession is mild, but other contractions—such as the Great Depression—are particularly severe and long-lasting. In a depression, many businesses close up shop for good.

If the economy looks to be suffering a severe contraction, the Federal Reserve tends to lower interest rates so that consumers and businesses can borrow money on the cheap for spending and investment. Lawmakers may tweak tax policy and/or call on the Treasury Department to issue economic stimulus in order to stoke consumer spending and demand for goods and services.

Phase 4: Recovery. The recovery phase is when the economy hits its trough, bottoms out, and begins the cycle anew. Policies enacted during the contraction phase begin to bear fruit. Businesses that retrenched during the contraction begin to ramp up again. Stock values tend to rise as investors see greater potential returns in stocks than bonds. Production ramps up to meet rising consumer demand and with it, business expansion, employment, income, and GDP.

While one might argue that stage-3 depths on some of the data featured above are getting close (a scenario we're for sure open to, and watching out for), when we take it all in, it looks to us like the economy presently sits somewhere between stages 2 and 3.

As for those investor questions posed by Howard Marks:

1. Are we close to the beginning of an upswing, or in the late stages?

Here again is the corporate profits and SP500 chart:

2. If a particular cycle has been rising for a while, has it gone so far that we’re now in dangerous territory?

Well, with regard to the US stock market, here's the current (yellow circle) price to earnings ratio for the S&P 500:

Price to Sales Ratio:

Price to Book Value Ratio:

Whether or not you'd deem the above valuation metrics as being in dangerous territory, I think we'd agree that they don't look the least bit bottomy!

3. Does investors’ behavior suggest they’re being driven by greed or by fear? Do they seem appropriately risk-averse or foolishly risk-tolerant?

Well, our own "fear/greed barometer" reads at a very high net-greed level: 

As does Citigroup's "Fear and Greed Index:"

Suffice to say that investor behavior is presently -- and dangerously -- driven by greed!

4. Is the market overheated (and overpriced), or is it frigid (and thus cheap) because of what’s been going on cyclically?

Well, per the above, we can't remotely claim that the market is "frigid (and thus cheap)."

5. Taken together, does our current position in the cycle imply that we should emphasize defensiveness or aggressiveness?

You tell me!

Well, shoot, this one's gotten long already... I guess I felt the need to expand a bit more on why, in our view, there's likely more to play out in the present cycle... So it'll be Part 6, the final part, where we explore the best setups for the next cycle.