“Intelligence is the ability to adapt to change.”

Stephen Hawking


The economic news over the last month has been as awful as anyone alive has ever seen. Unemployment has risen from 3.5% to 14.7% since February with nearly 15 million Americans filing for jobless benefits in the last month alone. The CFNAI hit its third-worst reading ever and that was for March so a new record is likely (interestingly, the worst reading ever was in 1974; the 70s really were pretty awful). Factory orders, Industrial production, and durable goods orders all declined by double-digit percentages. Exports and imports both fell as global trade imploded. Retail sales fell 16% and the savings rate rose to over 13%.

In the midst of this economic carnage, the S&P 500 fell….0.3% (not including today, when vaccine optimism is pushing the market higher). If you needed proof that the stock market and the economy are only passing acquaintances, the last month provided all you should need.

Stocks are not the only markets stabilizing though so maybe there is more to this than first meets the eye. Oil prices fell from $25 to somewhere south of zero and are now over $30. Copper is called the commodity with an economics degree and it is unchanged over the last month but 20% off the March lows.

And there were even some relative economic bright spots. The housing market seems to be holding up pretty well with low mortgage rates no doubt playing a role. Personal income was down 2% in March, but was still up 1.4% year over year. That isn’t very good but it is consistent with past recessions; nominal income fell in 2008 but that was an outlier. Real incomes are a different story and we will probably see those turn negative this month but again, that is pretty normal in recession.

So, what has changed over the last month that was positive enough to get markets off their lows? It may take a long time for the economy to recover to where it was prior to this sudden stop (and that wasn’t as good a place as it seemed in any case) but markets don’t wait for full recovery. The economic data of the last month continued to get worse, but the rate of change slowed – things are still getting worse but at a slower pace. That’s a first step on the road to recovery and was sufficient to take the Great Depression style worst-case scenarios off the table. At least for now.

There has been a lot of attention paid to the rally off the March lows but less to the longer-term damage. The S&P 500 is still down about 15% from its February high, but that isn’t particularly significant. That magnitude of drawdown happens frequently although the 35% decline at the lows is certainly less common.

What is more concerning is what has happened over the last two years. Stocks are essentially unchanged since the beginning of 2018 amid heightened volatility. The volatility index traded over 35 three times during that short span and has exceeded 50 three times since August of 2015. The VIX, as currently calculated. has been around since 1990 and never exceeded the 50 level until 2008. It has now done that three times in just over 4 years. The returns since 2015 have been more than acceptable but the path to achieving them has been difficult, to say the least.

Indeed, investing since the turn of the century has been challenging. Stock returns have been about 1/3 below the long-term average and bond returns have been, believe it or not, about average. And that assumes you were able to stay fully invested through two speculative manias (maybe three), three recessions, three bear markets, and record volatility. It has not been an easy ride.

The above also assumes that you were invested solely in US assets. The last ten years seem to prove that keeping your portfolio invested close to home is good advice, but you could have improved your twenty-year returns by including some non-US assets. It is easy to forget – time playing tricks once again – that international stocks outperformed US stocks for the first decade of this century by a considerable margin, a near mirror image of the last decade.

The same can be said of growth stocks vs value stocks and large-company stocks vs small-company stocks. The last decade has dramatically favored the former while the previous decade favored the latter. What will the next decade bring? I don’t know obviously but the last two recessions and bear markets did produce dramatic shifts and this one may as well. If so, there will be a large tactical opportunity when the economy starts its recovery.

We associate the divergence of returns among these assets with shifts in the economic environment:

The last decade has been spent largely in the first box of Growth Rising, Dollar Rising. The previous decade was spent largely in the second box of Growth Rising, Dollar Falling. The last three recessions, including this one, were spent mostly in the last box of Growth Falling, Dollar Rising.

So, where are we today? Still firmly in the last box, unfortunately, but as I said above, the second derivative of growth is slowing. That could be a first step to a classic recovery where the economy stops getting worse and then turns up and continues in an uptrend until the next recession. Or it could just be a first attempt at breaking the downtrend that fails. We don’t know yet. But as long as we are in that last box, caution is warranted.

It is important to note that even in this rally off the lows, none of these trends have changed. Growth is still outperforming value. US is still outperforming the rest of the world. Large company stocks are still outperforming small company stocks. Is another big shift coming? As Stephen Hawking said, “Only time (whatever that may be) will tell.”