Ecoinometrics - Bear market mindset
Bear markets aren't made to cry in the the fetal position in the corner of the shower. Believe it or not they are a great time to hunt for asymmetric bets.
Inflation is sticky and the Federal Reserve is starting to hit risk assets with the big stick. So you might be tempted to call it quits and go cry in the shower.
The thing is though, bear markets don’t last forever and their might be great opportunities just around the corner.
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Bear market mindset
Inflation heading back up in May was a surprise to a lot of people. I don’t know what the split is but judging by how the stock market puked last Monday a good chunk of investors must have been in the camp that inflation was coming down.
To some extent it must have been a surprise for the Federal Reserve as well. You know how they are all about not spooking the market. So if they had thought inflation would continue to head higher they would have certainly telegraphed this 75bps rate hike. The fact that they didn’t shows that once more the Fed is underestimating inflation.
Last week we talked about why energy prices in particular make inflation sticky (you can read it here) and why the Federal Reserve really can’t do much about that. Regardless the FOMC had to act strong on this one.
Remember, inflation is a political issue more than an economic one. Even if raising rates does nothing to the root cause of the problem it is there to send a signal.
And a 75bps rate hike is a pretty big signal. As a matter of fact, since 1954, 75bps rate hikes happened only three times. The Fed is really swigging the big stick at the market.
Check it out. I’ve plotted the distribution of the month over month changes in the effective Fed Funds rate (using the lower bound of the target range that is) over the past 80 years. We are literally at the top of the range. That’s how serious things are.
Yet, despite that we still have one of the largest gap on record between inflation and the Fed Funds rate. Exceptional situations call for exceptional measures.
How many more rate hikes can the Fed fit before the economy requires an end to QT? That’s the big question. If you look at the dot plot coming out of the latest FOMC meeting we are going to 3.4% this year and even higher next year. But of course that’s very dependent on the economic data. I mean last year the same dot plot was targeting 1.84% in 2022.
The economists at the Federal Reserve are just like everyone else. They don’t have any crystal ball giving them a peek at the future. For all we know the terminal rate might end up being around 1.84% this year. After all we are only at 0.77% right now with a recession that seems more likely by the day.
So how likely is it that the Fed bucks this 30 years trend of never managing to raise rates above the peak of the previous cycle? Very unlikely in my opinion.
Growth was negative last quarter and it will most likely be negative again. So while we don’t see any cracks showing up in the job market (yet), it is clear that the economy is heading towards a recession.
The stock market certainly is pricing one.
See the trajectory of this drawdown compared to the historical precedents on the chart below.
The beginning of the 2000s was defined by the Dotcom bubble. The end of the 2000s / beginning of the 2010s was defined by the Great Recession. Are the 2020s going to be defined by the coming recession? I’m not sure but that’s a possibility we have to entertain.
Now it is likely you haven’t been an investor during a recession before. Same thing for me.
The last true recession happened in 2008. Back then I was either finishing a MSc in physics or starting my PhD in math. Needless to say, I didn’t have any money to invest back then.
Something I’ve lived through though is a crypto bear market. I started investing in Bitcoin in 2016/2017 and just kept going through the 2018 crash and the ensuing bear market.
My reason to not sell it all back then is pretty much the same reason I’m not selling it all right now. We aren’t at the top of the adoption curve for Bitcoin and digital assets. If you go by conservative estimates, one Bitcoin could be worth around $150k if it reaches the market size of financial gold or up to $500k if it basically displaces the physical gold market.
This is a 7x to 25x growth potential over the next 5 to 10 years. So unless selling your holdings right now is already life changing, hodling on is a good asymmetric bet.
Now it is true that Bitcoin has never lived through a recession (we used some reasoning by analogy to see how Bitcoin might behave in a previous issue of the newsletter). But it is good to remember that crypto bear markets like full on recessions are temporary states of affairs.
Since 1929 we can count at least 7 major drawdowns for the stock market:
The Great Depression of 1929 was the most severe on record. The stock market dropped by 86% and took 25 years to recover.
The second one by severity is the Great Recession of 2008. But it doesn’t come even close to the Great Depression, a 58% drop and about 6 years to recover.
Then for a tie we have the Dotcom bubble and the crash of 1973. These two were 50% corrections that waited 7 years to make a new high.
The Black Monday and the Nixon Recession are also tied in terms of severity. About 36% drops that took 2 to 4 years to recover.
Finally the COVID crash stands out as the fastest to recover from such a large drop. The correction was 35% from the peak but it was all over in 6 months.
You can see a map of these corrections on the chart below.
So that’s one major correction every 13 years over the last hundred years. And you know what? The stock market is still up big time over the whole period. Between 1929 and 2022 the SP500 is up 200x. That’s something like a 6% annualized rate of return.
For sure 6% isn’t earth shattering. Nobody is going to get rich from that. People talk a lot about the power of compounding but honestly you don’t want to compound for 90 years and start enjoying your wealth at an age where you can’t tie your shoes by yourself anymore.
Still, if you are investing in the stock market as a tool for wealth preservation then sure 6% is pretty good.
Now coming back to the current situation, the question is to guess where this drawdown is likely to bottom at?
With the COVID crash we have seen that if there is the political will to pump the economy with fresh liquidity this can be done. So you can’t discount a fast recovery. That’s probably only possible after inflation starts to be on a declining path though.
For the more pessimistic scenarios I think we can safely discount another Great Depression. The global economy would probably not survive something like that. So as an upper bound for how long this situation could last I’d go with something similar to the Great Recession or the Dotcom bubble. That is something big, but not something that will last a generation. The world isn’t what it was in 1929.
Over the long run it pays to be an optimist with a sense of calculated risks. Since December of last year I’ve emphasized the fact that you should position yourself so as not to be liquidated in case of a sudden market downturn.
Looking at the misadventures of Luna, Celsius or the big hedge funds like 3AC those probably don’t read this newsletter. Or they thought the potential reward for them was worth the risk. I don’t know. What I can tell you is that since bear markets don’t last forever, now is a great time to put on some asymmetric bets.
An asymmetric bet is simply a bet where the potential upside dwarfs the downside risk. This is one of the best kind of bets for a few reasons:
Since the upside of these bets is typically massive, you don’t need to play with leverage. That gives you tremendous staying power.
You don’t need a lot of startup capital to make big net returns. That means those bets can be used for wealth creation, not only for wealth preservation.
Bear markets tend to accentuate the asymmetry of those bets. That is because prices are already depressed, the upside potential is higher while the downside risk is also decreased.
As we are heading deeper into this bear market I’ve been trying to decide what are the most relevant topics I want to cover for the investors reading this newsletter.
After some thinking I’ve concluded that the most valuable things I can cover for you are:
Analyzing the macro environment to figure out when the tide is starting to turn.
Finding and analyzing the asymmetric bets available to you in this bear market.
Some of those asymmetric bets are obvious and pretty safe, like buying Bitcoin now. We’ll try to build a quantitative framework around that to make this statement more precise.
Some of those bets are less obvious. Like which Bitcoin miners stocks have the biggest potential for long term growth? Coinbase has been trashed since its direct listing, does that mean it is dead or is it a great buying opportunity? There are certainly a lot of straight up scams in Web3 (read Matt’s 5 rules on how to avoid those btw) but are there some assets in this space that you can buy right now with a very high upside potential.
That’s the kind of thing we should be discussing in this bear market. There is no point crying about the price action right now. Better to spend time seizing the opportunities that will generate big returns when the risk-on season is back.
So if you aren’t subscribing already, join us while we try to figure this out during the bear market.
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