Recession Obsession and Behavioral Finance
See no evil, Hear no evil, Speak no evil. – Japanese Maxim
Nine things that may scare the pants off you may include roller coasters, horror movies, heights, flying, spiders, snakes, sharks, dentists and loud noises. A great recession market crash should be added as number ten. Today we will unpack the recession obsession mindset derived from investors anxiety over potential financial Armageddon that is fueled by the media and viral information online.
The recent stock market thousand point plus plunge along with the VIX “fear index” spiking may have incorrectly been construed as some sort of canary in a coal mine warning by the media. Yet, with two ongoing wars, presidential election candidate swaps, assassination attempts, bank failures, a worldwide CrowdStrike- driven Microsoft outage, the worst data breach ever into three billion individuals (almost every American), to the Japan yen carry trade unwinding and shocking the global markets, it’s starting to feel like we are living in a matrix of ongoing black swan events that most definitely are helping boost fear along with financial news shows ratings and viewership.
Jon here. Before you go and cash out your portfolio and pivot into cash, gold bars (now worth $1M dollars), crypto coins, whisky barrels, Rolexes, custom cars, non-fungible tokens, or a bigger mattress, take a big breath of air, and consider everything should work out over time if you are a diversified long-term investor, as it has for decades through both red and blue U.S. presidencies as well as all kinds of events. As we will cover below in our chart of the week, the stock market forges forward to new highs over time like a slow-moving cruise ship, through all kinds of weather conditions and swells.
It’s All in your Head
Believe nothing that you hear and only half of what you see, because many times the other half is an illusion.-Edgar Allen Poe
It can be a bit difficult not to be pessimistic when the negative news loops seem to gain traction more so than facts and figures that may indicate the opposite. Humans, it turns out, have what social psychologists call a “negativity bias”: We tend to pay more attention to bad-seeming information than good. This information then goes viral online.
Since the pandemic- inflation induced market crash of 2022, the word “recession” has frequently dominated U.S. headlines. Although exact counts vary, reports suggest that “recession” has been mentioned in the media hundreds of thousands of times during the past few years, amplified by online message boards and social media in vicious cycles. So far these market prognosticators have been 100% incorrect, while we have been on the soft- landing camp and staying on course with our clients.
There has been no lack in renowned business leaders providing Nostradamus-level recession predictions. These include Elon Musk, Cathie Wood, Larry Summers, Ray Dalio and even Jamie Dimon, the notorious CEO of JP Morgan, who warned of a potential “economic hurricane.”
Perhaps all the online noise about the recent “everything rally” with many parts of CPI taking years to cool off from housing to food and services that may eventually lead to an inflation induced recession has created an anxiety loop that may never cool off until it happens. At the same time, many disciplined investors are utilizing the Buffett maxim to get rich by “buying when others are fearful” and are focused to put as much money to work as possible while buying low through dips, corrections and crashes whether lump sum or through dollar cost averaging over time.
Four Drivers of a Recession
Despite all the recession obsession noise, the four main drivers of a recession include a credit crisis, commodity crisis, demand shocks or over valuations.
A credit crisis and demand shock example would be the 2008 Great Recession and subprime mortgage disaster, where excessive lending and poor credit practices led to a real estate bubble followed by the collapse of financial institutions. An example of a commodity crisis would be the Iran/energy crisis. This recession started in 1980 with the first Gulf War when Iraq invaded Iran. Oil shortages due to this war kept oil prices high while contributing to inflation. For an example of overvaluation, go no further back than the dotcom bubble days. Most tech and internet companies that held IPOs during the dotcom era were highly overvalued due to increasing demand and a lack of solid valuation models.
More than a few recession indicators appear to be broken including the inverted yield curve, the spiking VIX (fear) index, elevated inflation, and most recently, the Sahm’s Rule. This rule states that the initial phase of a recession starts when the three-month unemployment rate moving average is a half a percentage point higher than the 12-month low.
Rate Cuts and Landings
Many economists and students of the market may still have one last gasp of pessimistic air to cover, declaring that recessions typically begin after the Fed starts a new rate cut cycle. Still, correlation does not always indicate causation as history does not always repeat. The Fed controls the thermostat of the economy and decreases interest rates to help create more money flow in the economy from lending to investing. If you look back at history, many Fed rate cut cycles started after a recession had already started to help heal the economy. Today’s case of the Fed cutting rates before a recession is like administering a flu shot before flu season to help minimize getting sick.
Will we soon be partying like it’s 1995 when Fed Chair Jay Powell starts cutting the Fed funds rate probably as soon as next month? The 1995 Greenspan rate cut cycle coincided with disinflation and an economic soft landing that, importantly, did not morph into a recession. There are enough similarities that the [1995 cycle] could provide a potential roadmap for corporate earnings and equity prices in the coming quarters to keep an eye on. Still the odds have worked against the Fed historically to attain a soft landing.
Minsky Moment
As the economist Hyman Minsky explained, “the more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” The longer a trade works, the more willing investors are to steadily increase the size of their bets – just as a gambler does in a casino when they believe they are on a hot streak. Eventually, there is likely to be a “Minsky Moment” whereby the unwinding of the trade is worsened by leverage whether the recent unwinding of the yen trade to the 2008 credit crisis. Naturally, investors avoid the trade for some time, before returning and beginning the cycle anew.
This concept is crucial for investors since it highlights the importance of monitoring financial stability, and the potential risks associated with excessive optimism and risk-taking in financial markets. Most recently, this occurred in 2021 during the so-called “everything rally” following the pandemic. These periods are characterized by excessive optimism that is detached from market and economic fundamentals.
However, it’s also important to keep in mind that shocks to different parts of the market are not unusual, and not every potential source of fragility results in this level of volatility. Many economic cycles experience periods of expansion and contraction without triggering a crisis on the order of 2008. Last year’s banking crisis is a recent example of a serious issue that eventually stabilized. So, while vigilance is necessary, it’s equally important for investors to maintain a balanced perspective, recognizing that markets have historically demonstrated the capacity to overcome challenges.
Market pullbacks are normal and expected
Major stock market indices are still below their recent highs and it’s always possible that investor unease could continue. The Nasdaq recently fell into correction territory past 10% down, while the S&P 500 got only halfway there. Still, history suggests that pullbacks and corrections are not only normal but can also be healthy as markets adjust to new economic, market, and company data. The accompanying chart above (one of our most favorite charts) shows that the typical correction involves a decline of 14% on average (every year!), which then recovers within four months. The key, however, is that the recovery can begin when investors least expect it.
So, while day-to-day swings can be unsettling for investors, it’s far more important to understand the longer-term trends. The unwinding of the Japanese carry trade may have resulted in shockwaves across global markets, but there are signs that the situation is stabilizing. Focusing on the business cycle, corporate earnings, and underlying market factors can help investors to see past near-term volatility.
The bottom line? Markets have felt fragile due to both economic concerns and technical factors such as the Japanese carry trade. Rather than worrying about short-term market swings and the media’s recession obsession, investors should focus on long-term trends in order to stay on track toward their financial goals.
For more information on our firm or to request a complementary investment and retirement check-up with Jon W. Ulin, CFP®, please call us at (561) 210-7887 or email jon.ulin@ulinwealth.com.
Note: Diversification does not ensure a profit or guarantee against loss. You cannot invest directly in an index.
Information provided on tax and estate planning is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
You cannot invest directly in an index. Past performance is no guarantee of future returns. Diversification does not ensure a profit or guarantee against loss. All examples and charts shown are hypothetical used for illustrative purposes only and do not represent any actual investment. The information given herein is taken from sources that are believed to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as NewEdge Advisors, LLC does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.
