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  • Writer's pictureJonathan Wilmot

What Could Possibly Go Wrong?

Updated: Apr 8

Equity investors outside China should be a pretty happy bunch: Equity indices in the US and Europe (except the UK so far) have recently pushed above the the all time highs of late 2021, and Japan has even nudged above the bubble top of January 1990 - 34 years ago. In the US, the Bull/Bear ratio is at its highest level since 2022 and the number of US Consumers expecting lower stock prices in the year ahead is at its lowest level since the Pandemic struck.


And yet ...our most frequently asked question remains:


"What could go wrong?".


The short but not very helpful answer is 1) central banks could take too long to start easing policy in response to reduced inflation risk; 2) we suffer another significant energy price shock (which might delay central banks even further); or 3) we get a major political shock that changes expectations about the risks to global growth.


By way of broader context, we take a another look at the three very long cycles in US equities since the middle of the 19th century. By coincidence or not, significant declines occurred at the corresponding stage of the two previous long cycles, one of them associated with recession, one of them not, but followed in both cases by a 6 year bull run to secular peaks.


Let's take a closer look.


On our count, there have been three super secular cycles in US equities since 1850. The first ran from the panic of 1857 (equity trough in October); the second from the post-WW I deflation and Spanish Flu pandemic (equity trough in July 1920); and the third began during the Volcker Recession and International Debt Crisis of the early 1980s (equity trough in August 1982) and is still ongoing.


The first two cycles lasted 62 years and 10 months and 62 years and 1 month respectively, and both ended with a secular bear market phase that ran for roughly 13 years, during which real equity returns were flat to slightly down and very volatile. The first of those long bear markets included World War I (and the last global pandemic) and the second was the period of the 1970s oil shocks and stagflation.


As shown below, the real return profile of the current cycle has recently become quite closely aligned with the 1857 and 1920 cycles. So what happened at around the equivalent moment in cycles 1 and 2?


Figure 1:


Cycle 1: The Panic of 1899


In the last three years of the 19th century equities made a powerful recovery from the Great Depression of the mid-1990s: the Dow was up around 70% in three years. By early 1899 brokers were running aggressive campaigns to attract small investors into the equity markets, and the newspapers were referring to "giddy speculation". Everyone was bullish, the Great Depression all but forgotten. Not long afterwards the Bank of England (as influential then as the Fed is now) raised its key interest rate to 6% " to curb excessive strength in the economy". But according to the NBER the US economy wasn't that strong at all: it slipped into recession in June 1899 and real equity returns peaked a month later, declining 17.3% through June1900. The recession ended in December 1900 but it was the first half of December 1899 that saw the real drama in equity markets: the Dow dropped some 23% in just two weeks. The Wall Street Journal reported the collapse of a bubble in copper stocks, bank bailouts in Boston and a disastrous British setback against the Boers in South Africa as explanation, adding that "Complete demoralization then ensued, with money rates up to 186 percent, and with stocks being sacrificed regardless of price."


Cycle 2: The Kennedy Slide


By the time President Kennedy made his famous inauguration speech in January 1961, the US economy had been growing strongly for a decade or so, and memories of the 1930s were fading from memory. The economy continued to grow and stocks to perform well - for 11 months or so. But from December 1961 to June 1962 real equity returns slumped 23% in what came to be known as the Kennedy Slide. And they didn't really start to recover until after the Cuban Missile Crisis ended in October 1962. Equities in late 1961 were relatively expensive (equity risk premium just above 2%, for example) but there was no recession, no sharp tightening of monetary policy and no major bank failures or financial shocks. Yet that didn't prevent a loss of confidence in the outlook for growth and profits on the part of business leaders, a mood which spilled over into the equity market.And of course, when the Cuban missile crisis came it was - briefly- a potential existential threat. Had equities not already fallen sharply in the months before hand they surely would have sold off more aggressively during the standoff between Khrushchev and Kennedy


Figure 2:



Given our views on the transformation and productivity growth we remain long term bulls on (global) equities - through till 2030 or so. This year, though is another matter.


While history never repeats itself exactly, the charts below suggest that even a small loss of confidence could lead to a big corrections in equity prices. Our specific thoughts about risk can be summed up as follows:


A. It's almost certain that central banks, including the Fed will end up easing too late and/or too little. The harder question is whether that will do significant harm to growth or financial stability.


B. Given the explosion of interest in AI applications over the past year, it is extremely risky to be short of the Nasdaq, and perhaps especially Nvidia at the moment, no matter what you may think about valuation or future profit margins. Any thing that changes that equation would likely trigger a sharp bout of deleveraging. For example, a serious threat from China that they might impose a full scale blockade on Taiwan - even if that was just for a week or two - in response to further "provocations" from the US or Taiwan's new President. Or for that matter, North Korea mobilising to attack South Korea, an outside risk that has certainly increased in recent months.


C. Trump: he will be the Republican nominee. He might become President again. His policy agenda is likely to spook investors rather than the other way around. Once we get past Super Tuesday on the 13th March, that is going to become a much bigger focus.


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