This morning, within 15 minutes of markets opening, the ASX was down about 5%. Virtually every stock was down.
Today’s market reaction is largely attributed to higher-than-expected inflation (especially in the USA). While I’m certainly not able to predict what inflation will be, it’s certainly no surprise that inflation is smashing stock markets. However, one subject I haven’t written about is recessions. These are usually defined as two consecutive quarters of negative GDP growth, and we may already be in one.
As an aside, if you’d like to listen to a podcast discussion about the market thoughts, then I recommend the latest episode of Baby Giants Podcast, below.
Will There Be A Recession?
In my mind today is the day that markets started seriously pricing in the possibility of an earnings recession, not just a reduction in value of long duration assets. The sudden and volatile nature of the drop smells of panic. Now, I’m not saying that panic is unjustified, but since I already have plenty of cash, I’m not really inclined to join the selling (in the absence of disappointing news that is specific to an individual company, which did not occur for me today).
On top of that, I think that the current inflation is likely to lead to a recession. Once you consider the fact that many people have to spend a serious amount of their income on mortgage repayments, rent, energy and food, it is clear that current levels of inflation will leave the consumer with significantly less free spending money. That in turn should see less revenue for restaurants, shops and other discretionary spending businesses. Those companies in turn will respond by laying off workers, causing a recession.
When it comes down to it, I think there is about a 68% chance of a recession, which then heralds in another bull market. That is the normal way of things.
I think there is a perhaps 24% chance that we have a stagflation scenario, where we see an extended period of low growth and above average inflation. Specifically, I’m defining stagflation as an economic scenario with “stagnant demand and high inflation”. That’s my worst case scenario.
And I think that there’s a fairly thin 8% chance of a “soft landing”, where inflation comes under control so quickly that most economies avoid recession.
Keep in mind these are just my estimates, and they will definitely be wrong. I am making these estimates because I want to improve myself. In order to understand why I do this, check out Superforecasting: The Art And Science Of Prediction. If you have your own estimates, I’d be keen to hear them.
The reason I think that the goldilocks “soft landing” scenario is so unlikely is that in my mind the most likely thing that actually “cures” inflation is a recession.
Meantime, there is a lot of unproductive speculative capital in the system. I think stagflation kills many of these speculative assets, such as zero revenue story stocks, NFTs, and scam cryptocurrencies. But I think a recession is necessary to wash out some of the indebted, inefficient, and basically worthless companies that were given a lifeline due to covid stimulus.
In order to properly judge myself in calling this threat of recession, it’s worth taking a look at how my thoughts have evolved with regard to inflation.
I Have Previously Underestimated Inflation
In December 2021, I wrote that “I suspect that this growth stock sell off will run until inflation starts falling (I do not know when that will be)”. In that same article, I also mentioned that, “It is likely that high multiple growth stocks will continue to have a very volatile time,” and “For this reason, I have begun shorting stocks again, as a short term hedge.” While that was roughly right, it was also fairly soft considering that I was writing at basically the peak of the market. Many growth stocks have since fallen more than 50%!
However, it’s interesting to re-read that article, because I thought that the ongoing impacts of covid would be part of the narrative. That has not been the case. In some ways I was (partially) right for the wrong reasons.
More forgivable was that I didn’t foresee the war in Ukraine, or the massive increase in the price of energy. Both these things are making inflation even worse than I expected, at the end of 2021. As a result, I was content to be over-invested in property, back then.
By March 2022, I was selling the bounces, rather than buying the dips; and selling for prices much lower than I could have in December. It hurt to sell then, but I’m glad I did. When risky stocks rallied on March 10, 2022, I wrote before trading that “I’ll probably use today as an opportunity to reduce my position size in some of my higher risk investments”. I had finally taken the inflation message more seriously (and by now I could see the sanctions on Russia would make it worse).
My articles track my psychology over time, as I observed inflation; and acted too slowly. At least by April 2022, I had delved into Warren Buffett’s letters to shareholders in order to refresh myself on How Warren Buffett Says To Invest During High Inflation. Even though many people are sheltering in commodities, I appreciated the reminder that what really fares best longer term, is genuine pricing power.
By May 2022, I was outlining why I was no longer ignoring rate rises, and indeed, that revelation has lead to the biggest decision yet, to sell our investment property. Words can scarcely describe how annoyed I am that we didn’t sell the property in December last year, but I guess it’s difficult to pick the top, and we did not feel it would have been appropriate to put that on our tenants, at the time.
So, that leads us to my June 2022 “macro check-in”, on a day when the entire market fell by about 5%, at one stage. For me, I refuse to sell on panic days. That doesn’t mean I think that the market has bottomed, but it does mean that I’m acknowledging that I can’t make an unemotional sell decision on a day like today.
Instead, I checked out my pre-prepared list of 10 high quality stocks I like for the long term, and their target buy prices. I forced myself to make two small investments from that list. I also closed out one of the short sale positions that I’ve had since December last year, for a gain of ~75%. Truth be told, I’m expecting a small bounce tomorrow… but we shall see. Either way, bear market rallies are often very extreme; but they don’t mean the bear market is over. If we do get a bounce, I might increase a different short position.
But of course, I simply don’t know what the market will do from day to day.
Why I’m Still Sitting On Heaps Of Cash
At present, I’m still sitting on cash roughly equivalent to the value of my portfolio. So, if you included the cash on the sides, I’d have about 50% cash. On top of that, my cash coffers will increase significantly if we can get our investment property sold, in the next few months.
If and when we actually enter a recession, it may not last for long. Once the recessionary environment arises, demand for many goods and services will drop. That means just as the world is (I hope) ramping up energy supplies, demand for services like travel should decline. And if house prices fall, people will (eventually) end up spending less on their accommodation.
In many ways, a recession that kills demand is preferable to stagflation, for stock market investors. In a stagflation scenario, very low growth won’t provide impetus for sufficient pay rises to improve spending, leading to lower profits for corporations, and lower standards of living for workers. I expect governments will seek to avoid that through fiscal stimulus. To my mind, the best investment scenario is a recession, because that should offer up some attractively priced assets, and may lead to a faster rebound in both the economy, and markets.
When Will I Invest A Lot More Capital?
Obviously, I don’t know when the stock market will bottom. However, I do think it’s useful to think about what I’d expect to see before stock prices reach their nadir. Here are 6 signs that I should invest more heavily. I don’t expect to see all of these, but each one would encourage me to deploy significant capital.
First; I expect to see at least some bankruptcies before this sell-off is over. I think that the world has far too many zombie companies that are unproductive and need to go bankrupt in order for capitalism to work properly.
Second; newspapers will start screaming about recession, rather than merely inflation.
Third; people will stop talking about investing in NFTs, because they are mostly not investments, but simply gambling.
Fourth; almost all cryptocurrencies except for bitcoin and ether will basically fall 80% – 90% or go to zero.
Fifth; home prices will fall at least 10% overall, and 20%+ in some areas.
Six; fiscal stimulus, falling inflation, and/or interest rate reductions.
Taking a wild guess at it, I don’t think I’ll make a meaningful dent in my cash kitty until September this year, after results start rolling in. While I’m not selling any more stocks to raise cash now, I’m still looking to build up my cash through selling my property (and private company shares too).
Please remember that these are personal reflections about markets by an author. This article should not form the basis of an investment decision. It is an investment diary valuable only for the cognitive process it demonstrates. We do not provide financial advice, and any commentary is general in nature. Please read our disclaimer.
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