Market boulders rolling up and down

While stock markets are like boulders rolling up the hill, you are left with a sense of hope every time, that this time will be different, hoping that just once, they would go up and stay there without rolling back down.

In his book, The Philosophy of Recursive Thinking, Manfred Kopfer suggested that a good solution to Sisyphus’s punishment may have been to pick up and carry a rock or two down with him, and over time, level the hill in the process. This proves that we do not only have the opportunity to learn from our mistakes, but also to improve as a result thereof. The Sisyphus myth can be debated in a number of ways, but the fact remains that as time progressed, he should have become wiser, stronger and improved his technique in such a way that he could find an easier way to the top. Everything counted in his favour to eventually shorten the time it took him to get to the top.

Until fairly recently, we saw how market boulders were rolled to the top of the hill and how investors hoped that just this once, it wouldn’t roll back down. But they did.

Graph 1: S&P500 1-yr Forward PE

Source:(Refinitiv Eikon)

Instead of attempting to show readers when to call the next top or bottom of the hill, I am going to point out a few things that I have learnt over the years by watching these boulders rolling up and down the hill, which may help you to structure your investment portfolio correctly. I will mainly focus on the USA, seeing that as at the end of September 2022, they still made up 62% of the total MSCI All Country World Index.

The US hates recessions

That goes without saying. I mean, which country or reserve bank actually likes recessions? Over the past 25 years, however, the US has repeatedly shown the world that they absolutely despise it when the economic growth boulder rolls down the hill. A good indicator to see how close we are to a recession, is the US ten-year Treasury Constant Maturity minus the two-year Treasury Constant Maturity rate. When we look at the 45-year historical difference between these two rates, you will see that every time the short rates traded higher than long rates (i.e., where the difference was negative), the USA experienced a recession within the two-year period that followed.

When we examine this data more closely, you will see that over the past 25 years, the US acted very quickly to relax their interest rate policy each time the indicator turned negative, just as it is now. Make no mistake – inflation remains a problem, but data released over the past two months actually does indicate that the rate at which inflation is increasing, is slowing down. Personally, I will keep a very close eye on this. We know that further interest rate hikes are expected, but if we are approaching the end of a rising interest rate cycle, it may not only raise questions about equity valuations in world markets, but definitely also about the US dollar trading somewhat stronger than it should.

Graph 2: US Fed Fund rate, USD Index & US recessions

Source: Refinitiv Eikon

The US dollar and risk investments

Over the years as the market boulder has rolled up and down, it has become clear that at times like these, investors tend to run away from risk, including shares and bonds, and run towards the US dollar. This was also the case during the 2008 financial crisis.

During the 2008 financial crisis rolling boulder, we saw that a 60% investment in the S&P 500 Index paired with a 40% investment in the US 10YR Treasury Index declined by more than 20%. Over the same period, the US dollar (US Dollar Index) strengthened by more than 20% year-on-year. This resulted in a massive inverse movement when markets started to stabilise. Am I saying that stock and bond markets cannot expect further pressure? Not at all. Nor am I saying that it’s impossible for the US dollar to experience further strengthening. What I am saying, is that I have seen this specific boulder roll up and down the hill before.

Graph 3: US 60/40 (S&P500 Composite Index (TR) & US 10YR Treasury Index vs USD Index (YoY %)

Source: (Refinitiv Eikon)

Gold and the US Dollar

It’s always interesting to note that all markets and investments’ boulders cannot be found at the top or bottom at the same time. Let’s use the gold price and the US Dollar Index as an example. A popular view is that gold acts as a defensive addition when markets turn negative. The problem with this is that when the US dollar boulder rolls up, the gold boulder usually rolls down. Of course, the inverse is also true. Over the ten-year period between February 2002 and February 2012, the US Dollar Index rolled down from 119 to 78, while the gold price rolled up from $300/oz to $1 700/oz.

Graph 4: US Dollar Index vs Gold Price  (US$/oz)

Source:(Refinitiv Eikon)

Of course, I’m not saying that the boulders will roll exactly in the same direction and time frame as they did in the past, if at all. But it’s always wise to look at historical data when it comes to future positioning.

I don’t expect the markets’ hiccups to simply vanish over the short term, but we should learn from the past and try to avoid making the same mistakes. Sometimes doing nothing is doing something and the best strategy.