Looking Down the Barrel of a Gun

Looking Down the Barrel of a Gun

by Zach Marsh on Apr 24, 2020


“When I was your age, they would say we can become cops, or criminals. Today, what I’m saying to you is this: when you’re facing a loaded gun, what’s the difference?”

Frank Costello, The Departed

A few morning’s ago, I awoke with this line stuck in my head. I was trying to internally reason with the much of the conflicting opinions on the outlook of the stock market and the direction of the economy. Many prognosticators are happy to inform us that our current environment is different, read better off, than 12 years ago, because that was a financial crisis and right now, we don’t have a financial system on the brink of collapse. My question for these people is this: given that so far over 26 million people have lost their jobs, and millions more seem certain to join them; given that we are waiting for a vaccine or herd immunity to restart our economy, an outcome that may take much longer than originally anticipated; and given that our government is joining our corporations, our municipalities and our citizens in going deeper and deeper into debt; my question, I guess, for these prognosticators is this: when you’re facing a loaded gun, what’s the difference.

I know I must seem like a “Debbie Downer,” after all the stock market is now in bull market territory, having bounced a confounding 28% since the lows last month. Maybe things aren’t as bad as I’m making them out. Maybe things are turning a corner. Maybe we are beginning to coexist with this virus and normality will return and our economy will start booming again. I’ll readily admit that I may not have all the details, that in my singleness of mind I’m overlooking many potential positives and failing to see how much negativity has already been priced into the market. Somehow, though, I don’t think I’m wrong. But then again, the facts of life are that we rarely, in moments of certainty, can be persuaded that we are wrong. Acknowledgement of this blind spot at least prepares me for the potentiality of my flawed logic, I hope.

Last week, I covered the history of swift and large rallies in the stock market. I mentioned that all of these happen in bear markets, but that the forward outlook after these moves is somewhat muddled. A lot depends upon where the market has already been and where the economy is on the road to recovery. Currently, this rally has yet to show signs of being anything more than a bear market rally, a bounce back on the path to potentially future lower levels. The Federal Reserve has pulled out its full arsenal and attempted to back stop the losses and prevent further economic damage. But the effectiveness of many of these remedies ultimately relies on the cooperation of the patient rather than the prescription.

At present, this patient, the US and global economy looks sick and unresponsive, while the stock market continues to send of contradictory signals. Much of this can be directly tied to the $6 trillion dollars of direct fiscal and monetary stimulus added to financial markets. How far this stimulus can carry us remains in question. We’ve long since abandoned the playbook of capitalism and have picked up the playbook Japan has been following for over 20 years. These extraordinary steps taken by the Fed, both by failing to unwind much of the stimulus put in place following the last crisis and by then adding more fuel to the fire, have made one thing abundantly clear: If there are no atheists in a foxhole, then there are clearly no capitalist in a freefall. We have lost faith in a system that requires periodic setbacks or retracements and have gone all-in on a system of a centrally planned economy.

One system creates opportunity for reward by allowing the potential for risk which allows for risk assets to be discounted, the other creates an environment of perpetually inflated risk assets via the belief that all risk will be backstopped by the government. The second system can appear to continue indefinitely but ultimately seems to end in collapse. Fully centralized economies of the past have failed miserably as exemplified by the Soviet Union. The Japanese rabbit hole we’ve gone down has shown poor results as well. As 21st century Americans we have tremendous faith that financial markets bounce back, normally in fairly quick order.

Yet if we look outside of our borders, we can see that this is not necessarily the general nature of markets. Case in point, the Japanese stock market index the Nikkei 225 reached a level of nearly 39,000 back in 1989, as recently as 2009 it traded as low as 7,000. The Nikkei 225 currently sits below 20,000. In fact, the index has yet to recover its highwater mark at any point in the last 31 years. More examples exist of these prolonged drawdowns. The French CAC 40, the leading French stock market index, currently sits 33% below its highest-level set in 2000, it too has yet to see those levels since that point. The FTSE 100, the UK’s leading index is 13% below its highs from 2000.

Perhaps we can hold out hope that the fate of our country is not to be the fate of these others. Certainly, there has been an economic shift from a United States and European world power base to a Sino-US power base. But even in China, as its economy has expanded rapidly over the last 20 years, its stock market has not fared the same. The Shanghai Index trades for about half of its highest-level set in 2007, it also has never recovered its highwater mark in 13 years. The history of financial markets is littered with these examples.

Because we cannot be certain in our uniqueness, in fact we are not really unique because from 1929-1954 our stock market traded below its highwater mark, we must continually look to diversify risk. Even at low interest rates bonds continue to provide a buffer for stock market risk. Gold, over the last 20 years has also proven to be a valuable asset for diversification of risk. Policies designed to mitigate investment risk have had the result of driving up the prices of most asset classes, which has resulted in greater challenges for traditional risk management via diversification.

Relying on traditional 60/40 stock bond allocations will most likely fail to provide adequate protection should this downturn in the market resume and worsen. We believe that an adaptive, risk parity balancing, has the ability to improve risk mitigation versus traditional models and the stock market in general. The future will forever be murky but we need to position ourselves for a variety of outcomes, and that begins with proper portfolio construction.      








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