Market At The Crossroads

I went to the crossroad, fell down on my knees

I went to the crossroad, fell down on my knees

asked the lord above “have mercy, now save poor bob, if you please”

Yeoo, standin’ at the crossroad, tried to flag a ride

ooo eee, i tried to flag a ride

didn’t nobody seem to know me, babe, everybody pass me by

standin’ at the crossroad, baby, risin’ sun goin’ down

standin’ at the crossroad, baby, eee, eee, risin’ sun goin’ down

i believe to my soul, poor bob is sinkin’ down

Robert Johnson

A lot of people know the song Crossroad Blues, although I imagine most people don’t know it as a Robert Johnson song. It was originally recorded in 1936 in San Antonio for ARC records along with some other Johnson songs that aren’t known as Robert Johnson songs, including Sweet Home Chicago and Terraplane Blues. It was later recorded by Elmore James in the 1950s and again by Eric Clapton (with Stevie Winwood on vocals) when he was part of John Mayall’s Bluesbreakers. God Clapton recorded it again when he formed Cream with Ginger Baker and Jack Bruce in the late 1960s. But my favorite version of the song is by Ry Cooder, an underappreciated guitarist probably best known, especially here in Miami, for his association with the Buena Vista Social Club.

So, the song has been around a long time and it has been recorded countless times. And if you mention the song to someone who knows it they’ll tell you it’s about Robert Johnson (or more likely, a generic blues guitarist) selling his soul to the devil in exchange for guitar talent. The Ry Cooder version of the song is from a movie – not a particularly good one I might add – that tells a version of this myth, albeit a kind of beige one with Ralph Macchio and Jamie Gertz.

And yet if you read all the lyrics, you will be hard pressed to find anything that even remotely supports that assertion. You can listen all you want but if you think the lyrics support that interpretation you are hearing what you want to hear. Now, there is, possibly, some social commentary in the song when he says “risin’ sun goin’ down, I believe to my soul, now, poor Bob is sinkin’ down” as that may be a reference to sundown laws, curfews for blacks during segregation in the south. But more likely the song is just a lament about not catching a ride at the crossroads – which is where anyone hitchhiking in the south back then would have stuck out their thumb – and not having a woman to keep him company. Sometimes things are just what they seem.

Investors do this all the time, see what they want to see, hear what they want to hear. Or sometimes see and hear what someone in a position of power wants them to see and hear. Their internal bias, their desire for a particular outcome, clouds their judgment and doesn’t allow them to see markets as they are. Everyone wants to know the future, thinks they need to know the future, to invest wisely and so they see in markets confirmation of what they already believe – or hope – about how that future will unfold. This is particularly so after big changes in the market as we’ve had in the last few months.

Most of what passes for “investment advice” is nothing more than speculation about an unknowable future. I read an article today – I won’t link it because it was the worst kind of linkbait – that the title implied would explain why 2019 would be “a bad year for markets and 2020 would be even worse”. When I clicked through, the only supporting evidence for this “case” (as the title called it) was a hedge fund manager claiming that we are “definitely in a bear market” and that today’s market was a “re-run of the dot com crash” at the turn of the century.

There are at least two problems with this “analysis”. First of all, there is no agreed upon definition of a bear market. The one most often cited is a 20% drop from a high but that isn’t as cut and dried as it seems. Is that from intra-day high to intra-day low? Or closing high to closing low? If it is the former then we are indeed in a bear market. If it is the latter, we aren’t.

Furthermore, how do we define when the bear market is over? Is it when you surpass the old high? Or some other recovery level? I don’t know and I don’t know how the hedge fund manager defines these things. But perhaps more importantly, what difference does it make? What happened in the past already happened – a 20% drop – and has no bearing on the future. What good is it to tell me we are in a bear market? What does that mean?

Second, is that there are very big differences between the technology stocks of today and what was hot back in the early dot com days. Most of the hottest stocks back then didn’t have P/Es because they had no E but the multiples put on the ones that did were several orders of magnitude beyond the hottest stocks today.

Yes, Netflix is expensive at around 50 times next year’s estimate but in 2000 Cisco had a forward multiple almost 4 times that. Oracle traded for 150 times earnings. The top 10 companies in the S&P 500 had an average multiple over 60. Today’s top 10 does include Amazon with a trailing P/E of about 80. The other tech names are much more reasonable: MSFT (25), AAPL (14), FB (21), GOOG (25). They might not be value investor bait but they aren’t dot com bubble days either.

This type of “analysis” is what investors are bombarded with on a daily basis, fear mongering based on nothing more than a desire to get quoted by CNN. Macro economic “analysis” is, if anything, worse because it is even more esoteric than stock analysis. No one can possibly fathom the interactions, the voluntary and involuntary exchanges that happen in a global economy of nearly 8 billion people.

The desire to predict the economy is so strong that people who are happy to explain to you why socialism doesn’t and can’t work are also happy to provide you with an estimate of next quarter’s GDP growth to a tenth of a percent. Or opine on the latest economic data release which is nothing more than an estimate that may prove wildly inaccurate when the actual data is all collected. Their alleged ability to predict the future based on incomplete data today is exactly what they say a socialist can’t do. And yet they seem to have an incurable urge to prove the point by trying to do what they know socialists can’t.

Investors stand at the crossroad of bulls and bears, afraid both that the bulls will pass them by and that the bears won’t. They want to believe the bulls but are mesmerized by the convincing arguments of the bears. With no way to judge the merits of the two cases, most investors become paralyzed, afraid to make a wrong move. And most of the time that’s okay, assuming you are already in the market, because the bears may be more erudite than the bulls but they are also usually wrong.

The markets and economy seem to be at a crossroad right now, investors wondering whether the tumult of the fourth quarter was just a warm-up for more pain down the road or a mere pause that refreshes a bull market that has endured more than its fair share of skepticism from its beginning. The fears of the bears and the hopes of the bulls aren’t much different today than they were in 2010, 2011 or 2015.

There are plenty of things to worry about today just as there was in those other years. The Fed could make a mistake. China could devalue the Yuan. Trade negotiations could stall, more tariffs applied to foreign goods. Europe could still fall apart. Brexit may happen or may not (I’m not sure which thing is negative this week). Democrats could make life miserable for President Trump. There are always things to worry about. But should you?

As with the song Crossroad Blues, it is probably best to see things as they are, take things at face value. Stock market corrections – falls that aren’t associated with a recession – are impossible to predict. They happen regularly and investors would be wise to see them for what they are – random bouts of selling driven by emotion rather than fact.

The selling we saw in the 4th quarter was driven by a fear of Federal Reserve policy, fear that they would tighten monetary policy too much and cause a recession. But there was no evidence of recession at the time, no evidence it was imminent and none even now. There was only fear that a downturn might arrive at some point in the future because the Fed might hike interest rates too far.

I do believe one should monitor the economy but there are ways to do so without speculating about the future. Interpreting the present is hard enough but predicting the future is impossible. Markets are not perfect but they will provide you with all the information you need to be forewarned that the odds of recession are rising. Bond markets are particularly helpful in that regard. Stock markets are not.

Correctly identifying a recession in real time is useful because stocks will likely fall much further than they did in the most recent correction. The last two recessions saw stocks fall by roughly half. That doesn’t always happen – the market only dropped 20% during the 1990 recession – but with valuations as high as they are today, one should probably expect a big drawdown.

There are only a few things you need to watch to stay informed and keep your cool when stocks are trying to scare you to death.

• Yield curve – The difference between short term and long term rates. If you’ve been reading the financial press for any time at all you know that an inverted curve – short rates higher than long – is a warning sign for recession. That is true but not the end of the story. Right before recession you should expect to see short term rates drop rapidly and the curve to steepen. As of now, the curve has not inverted and is not acting as we would expect prior to recession
• Credit spreads – The difference in yield between junk bonds and Treasuries. At the onset of recession, spreads will widen as investors start to avoid risky debts. Widening by itself may not mean much; look to the yield curve for confirmation. Today, the curve has widened some but not enough to worry about recession. And the yield curve doesn’t confirm anyway.
• Chicago Fed National Activity Index – The CFNAI is a monthly gauge of overall economic activity and inflationary pressure. It is a weighted average of 85 separate economic indicators constructed to have an average value of zero when the economy is growing at trend. It has a standard deviation of 1 (range is +1 to -1). When the gauge is positive the economy is growing above trend and when negative the economy is growing below trend. Use a 3 month moving average to smooth out volatility. A reading of -0.75 is a warning of imminent recession. The current reading is 0.12 showing growth slightly above trend.
• Conference Board’s Leading Economic Indicators – The LEI has 10 components and a long track record. It isn’t as broad as the CFNAI but does have a track record of turning negative year over year prior to recession. The latest reading in December was 111.7 versus a year ago reading of 107.

The economy is a wildly complicated, chaotic system composed of billions of individuals pursuing their own or others interests. It is, like all other chaotic systems, impossible to predict precisely. Luckily, investors don’t need a high degree of precision to succeed. If you can come within six months of identifying the onset of recession – that’s a full year window – you can probably avoid the worst of whatever bear market comes with it. These four simple indicators are sufficient for that task.

What you really need though is a strategy that allows you to completely miss the recession call and still survive the bear. That means having an asset allocation that you can stick with and achieve your goals no matter what happens, short of nuclear armageddon. The 4th quarter tumult was a tempest in a teapot, easily weathered by those with the comfort of knowledge and a reasonable, well thought out strategy. If that doesn’t describe your experience, you probably need to revisit your plan. Or get one.