Source – Ned Davis Research
When asked for a market forecast, J.P.Morgan replied – “it will fluctuate, young man, it will fluctuate.”
Now, Mr. Morgan must have been a pessimist because the S&P 500 has surpassed even the most optimistic forecasts by averaging a 6% annual return over the past century. Before you get excited and jump aboard this cruise ship, pack some Dramamine. This is a rocky ride. There have been periods of intense euphoria, gut-wrenching anguish, with periods of utter boredom in between. Quite analogous to the past 5 years, the 1920s, the 1960s, and the 1990s were bull markets fueled by innovation. The S&P rose 213% between January 1995 – January 2000, a 26% annual return. Post-Y2K, markets hit rough seas. From the peak of March 2000 to the trough in March 2009, the S&P lost 56% or 8% annually. A ship lost at sea. The 1970s were dominated by inflation, commodity shortages, and volatility, but a decade where markets were flat as a Royal Caribbean pancake. This begs the question, what are the fundamental reasons for markets to behave in such a manic-depressive way?
What Drives Market Fundamentals?
Like any economy, the markets also go thru cycles. These cycles are a byproduct of three larger cycles: 1) Demographics, 2) Business and 3) Central Banks. When these three are in unison, markets advance like speed boats. The fantastic returns from 2020-21 are a perfect illustration. So is the period from the late ’90s. However, when they work as a tandem in reverse, they produce the lost decade of 2000-09. Let’s dive into the specifics of each cycle and how it works.
Let's Talk Demographics.
Source – Ned Davis Research
Our economy grows when we collectively spend more. However, only structural factors can drive aggregate spending over a long period. A demographically driven growth spurt is one of those structural reasons. Simply, when a couple gets married and is close to having a baby, they buy a house. They buy a larger car. The household spends more. Down the road, they have another baby. They buy an SUV or a minivan and move to the suburbs! They are motivated to earn more because they spend more. When a large population cohort enters this life stage – think Baby Boomers in the late 70s and early 80s – it unleashes earning potential for businesses and opportunities for entrepreneurs. A rising tide lifts all boats. Demographic forces are measured in decades and provide structural tailwinds for markets over a long duration. Look at the chart above to understand the power of demographic inflections. The opposite creates a strong undertow that produces immense drag. The lost decade wasn’t an anomaly. Today, we are in the early innings of another structural acceleration. Millions of Millennials are entering a household formation phase, leading to another demographic inflection. What took place in the early ’80s is repeating again, today!
What is a business cycle?
Source - OSAM
A business cycle is simply a boom-bust cycle measured over several years. An event creates a disruption for business. To conserve cash flows, businesses reduce investments, inventories, and lay off employees. Consumers react and reduce their own spending. This virtuous cycle turns into a recession. Over time, as the impact wanes and spending troughs, consumers stop being scared and cautious. We start to spend again. Businesses gain the confidence that the economy has cyclically turned for the better, hire employees, and invest in plants and inventories. This leads to more hiring, more investments, and more consumer spending. The anguish from the ‘event’ fades into distant memory. Animal spirits return … just in time for another ‘event’ to sap our collective enthusiasm. We rinse and repeat. Business cycles, or boom-bust cycles, occur even in the context of a larger demographic cycle.
Central Bank cycle
Source – Ned Davis Research
The last, and arguably the most dramatic, is the Central Bank Cycle. Whether right or wrong, our Central bank, a.k.a The Fed has a two-pronged mandate; 1) maximize employment and 2) avoid extended bouts of high inflation. The Fed swoops in during a bust to protect the economy and jobs by reducing interest rates and by supplying excess money. In theory, this makes sense. This alternative money acts countercyclically when consumers and businesses are retrenching. This is how we get over the ‘event’. When the business cycle gains momentum again, the Fed removes its monetary help, hoping the businesses can be self-sustaining. However, if inflation rises too quickly, the Fed steps in. They tap the economic brakes. Reduced demand and business activity help to cool inflation. Although, the Fed’s track record is poor. Business cycles don’t generally end. The Fed ‘kills’ them by going too far. Look at the illustration above to see how markets follow Fed movements.
A Powerful Combo
To add context around these three cycles, think of ‘Covid’ as the event. Covid was the catalyst for ending the previous business cycle. Central banks around the world started a new cycle by pumping massive amounts of money. Covid accelerated a ‘Millennial demographic cycle’. Young city dwellers moved to the suburbs in droves in search of extra living space. Babies and minivans come next! A new business cycle was born. Businesses flipped from layoffs to hiring. Most of the jobs lost were recovered. This cycle is also atypical. What takes several years was accomplished in several months. The S&P rose 115% from March 2020 to December 2021. Now inflation is very high. The Fed support is at its apex. The business cycle could also be at its apex. Well, guess what, we have another ‘event’. Could the collateral damage from a war trigger another bust? Only time will tell.
History doesn’t repeat itself; humans do – A Wise Man
While the ‘event’ is always different, and extenuating circumstances vary, the chronology of boom-bust cycles is always the same. A wise man once said, “history doesn’t repeat itself, humans do.” Consumers and businesses act predictably to every boom and bust. However, the bust period is shorter and shallower if it happens in the context of a longer and more powerful demographic cycle.
Let’s go back to J.P.Morgan’s answer, “it will fluctuate, young man, it will fluctuate.” Markets do fluctuate short term. A hundred years of history also suggests that markets cruise long term. However, most investors miss out because they get greedy at peaks and fearful at troughs. At Latticework, we map the inner workings of cycles and the businesses they impact. We use this compass to deconstruct why markets do what they do and navigate the fluctuations. We can help, especially when the seas are rough. Reach out to us.
I am an investor and these are my personal thoughts on investing, behavioral finance, markets, and sports viewed through the prism of a Latticework