Coming into Focus

Roughly two months have passed since my last memo, Time for Thinking, and still not much has changed in the economy or the markets. The toll from Covid-19 continues to rise, the economic outlook is largely the same, vaccines remain some time off, and the S&P 500 is back where it was in early August. So I’ll repeat what I said then: it’s mainly been time for thinking. Fortunately, the more I’ve thought about the issues, the more things have come into focus for me. Thus, I’m going to use this memo to go into greater detail on a few topics.

The Prerequisite

In Time for Thinking I talked about the fact that I don’t consider this year’s developments to be cyclical. You could say, “Why not? The economy and the markets went down, and now they’re recovering. Isn’t that a cycle?” What I really mean is that this is very different from a normal cycle, and I’ve figured out a way to better explain that, borrowing a bit of what I said in my 2018 book, Mastering the Market Cycle.

Most of the up-cycles I’ve witnessed occurred because things were going well in the economy, causing psychology and decision-making to become increasingly optimistic and eventually euphoric. Corporations favored expansion, stock prices rose and financial innovation became possible, even encouraged. Eventually, productive capacity exceeded what was needed, stock prices exceeded underlying value, and shaky investment innovations were embraced. When these trends outstripped the fundamentals and became unsustainable, the result was a downturn. Often a recession triggered a market correction, and sometimes the impact of that recession was reinforced by negative exogenous events that further darkened the previously-blue skies.

A good example is the first non-investment grade debt crisis Bruce Karsh and I managed through, in 1990-91. There was a recession, exacerbated by the shock of going to war to help Kuwait repel an invasion by Iraq. The newly developed high yield bond market experienced its first major spate of defaults, the result of a recession and credit crunch and exacerbated by the prosecution of Michael Milken and the failure of Drexel Burnham, precluding remedial bond exchanges that otherwise might have helped companies stay alive. Stocks declined, but high yield bonds went into free-fall. Notably, many of the prominent LBOs of the 1980s – which had been financed with perhaps 95% or so of debt – went bankrupt. Investor psychology collapsed and bondholders headed for the exits.

A collapsing economy needs a good dose of stimulus to pull it out of its swoon, and that’s what occurred. Usually that’s enough. Eventually the economy recovers; consumers resume buying; investors regain their equilibrium – some even sense the bargains that have been made available; and the upswing takes the economy back toward good health . . . and the cyclical process continues.

So, most of the time, downturns stem primarily from economic weakness, and they are repaired with economic tools. But this episode is different. It was caused by an exogenous, non-economic development, the pandemic. The recession – rather than being the cause – was the result: a closure of business induced intentionally in order to minimize inter-personal contact and halt the spread of the disease.