The ‘Should Be’ Correction

It’s a familiar refrain: the historic rebound in equity and credit is detached from economic reality.

That, in itself, isn’t necessarily a “problem”. Wall Street isn’t Main Street. The stock market isn’t the economy. Fill in the blank with your favorite old adage.

Worn out clichés aside, it’s reasonable to expect some divergence between asset prices and the real economy. Markets are forward-looking after all. Equities tend to “pull forward” expected future outcomes. And when it comes to credit, the Fed is there with a literal backstop.

The worry, though, is that this detachment has reached a point where even adjectives like “absurd” aren’t sufficient to convey the scope of the disconnect. I expounded on that in “Dystopia Revisited“.

As we look ahead to the fourth quarter, and as market participants ponder the prospect that at least a portion of the summer tech surge was in some sense “artificial”, driven by the gamma feedback loop associated with speculative positioning both by retail and institutional investors, it’s worth taking stock of how far afield things are from the “typical” post-recession experience.

“The past few days’ drop in global equities is the third, mild correction since global markets bottomed in late March, but it will probably animate more discussions than previous episodes for one reason: the epicenter of Big Tech represents the greatest concentration issue that either Equity or Credit markets have faced in 50 years”, JPMorgan’s John Normand writes, in a piece dated Monday.

As ever, it’s important to note that there is no written “rule” which dictates that corrections will everywhere and always occur when things get “extreme”. Indeed, you could easily argue that the history of markets (of all sorts) is more “story of speculative bubbles and excess” than it is a tale of rationality and efficient pricing.

“This time is different” is a phrase we all hold up for the sole purpose of lampooning it, but the fact is, if everyone who claimed to understand why that phrase is dangerous actually believed it is, in fact, dangerous, then we wouldn’t have recurring manias and bubbles.

The reality is that everyone (or nearly everyone) gets swept up in some iteration of irrational exuberance at some point in their careers, even if, in the heat of the moment, we tell ourselves we’re just participating because we know there’s a “greater fool” out there. We never (ever) admit that our own participation by definition makes us a “greater fool” than the person we just bought from.

With that in mind, I’ll highlight the following set of visuals from JPMorgan which are just updated versions of familiar charts depicting the ferocity of the rally.

The bank’s Normand gently reminds you that the recent swoon “barely dents what have been some of the swiftest-ever retracements in Equity and Credit markets”.

He goes on to say that while markets generally find their lows prior to the end of a recession, and while asset prices are prone to recovering around 75% of the losses logged during recessions “within the first year of the new expansion”, it is exceedingly rare that assets “achieve in only four to five months what Equities and Credit have delivered since the spring”.

That’s one way of saying that we’re in uncharted territory, and that’s underscored by a hodgepodge of statistics which Normand calls “abnormal” in the context of historical cycles. There’s considerable detail in the full note, but summarizing, Normand notes that,

1. Global real GDP remains about 4% below pre-crisis levels, so almost equivalent to the Global Financial Crisis shortfall;
2. US unemployment is more than twice its pre-crisis level;
3. Global oil demand is almost 10% below pre-crisis levels, so twice as weak as the worst point of the Global Financial Crisis;
4. DM Bond yields that have risen the least-ever once a recession has ended;
5. Value stocks have delivered their worst-ever performance relative to Growth during a global growth upturn; and
6. The rally in EM Currencies is just average by the standards of a global growth rebound

All of that against the most aggressive, “V-shaped” recovery for equities in US history (or at least in modern US history) and collapsing credit spreads which have helped push all-in borrowing costs for investment grade US corporates to near record lows.

And yet, if asset prices no longer represent the real economy in any sense whatsoever, then who’s to say they have to close the gap with “reality”?

You think that gap should close. And I think that gap should close. But basing an investment thesis on normative concerns is never a good idea — let alone in a world that seems to drift further from what “should” be happening all time time.