The future might not be as gloomy as people think, because we already are halfway there. I’m talking about the prospects of recession on the market. Looking at the market behavior during past recessions, typically the broad market drops around 30% peak to trough and takes two to three years to recover. In a few cases over the past 80 years the market has gone down a bit over 50% — and taken over a decade to recover, a “lost decade”. Those stick in our mind but are not typical.
So we are over halfway there: The S&P 500 is 23% down from its peak. MSCI World is down 25%.
You might think with the recession knocking at the door that the market would remain spring-loaded for the real event. But equities anticipate what will be happening, and the dire world we are seeing now has been in the offing for months.
There is a good case to be made that this will be more severe than the run of the mill.
On the fundamental and economic side, we have inflation; geopolitical strains; information technology (e.g., XLK), down 30%, although with more room to go. There is a lot more risk there than in the market overall. And we have the emerging economic effects from climate change. Not yet part of the market equation, but as I went through in a recent post here, even today drought is affecting transportation, energy production and agriculture, and heat is affecting productivity broadly. Things will only get worse down the road, and the market discounts for the future.
In terms of market dynamics, which I focus on to assess the vulnerability of the market to stresses, we have high leverage, both among hedge funds and retail; high concentration; and low liquidity, now exacerbated by higher interest rates. (The higher rates also affects the funding for leverage, putting strains on those positions.)
The economic stresses might pile on, the market becoming all the more vulnerable with each, so we end up with a downturn that drops in steps and that lasts longer than a recession might standing alone. So think of a plane crashing into railroad tracks leading a train to derail, roll over a cliff and plow into a nuclear power plant.
