‘The Deadly Upas Tree of Wall Street’
“This tree… was said to be so exceedingly poisonous that no one could even approach it without certain death”
The 1920s and the Previous Pandemic Decade
(Source: Global Financial Data)
From the Archives
A list of my favorite historical sources for financial history.
“Hello darkness my old friend…” Anyone else seem to have Simon & Garfunkel stuck in their head after the week we just had? As the Bloomberg chart below demonstrates, the major US stock indices recorded their worst weekly returns since this whole nightmare escalated in March.
The article stated:
‘The S&P 500 slumped 5.6% in its worst week since March, led by shares of megacap tech companies that reported solid quarterly results just days earlier. Losses in the tech-heavy Nasdaq 100 exceeded 3% at one point on Friday. And in the options market — where open interest had exploded in single-stock calls ahead of earnings — bullish contracts expired next to worthless as the tech bloodbath dragged them out of the money…
While the Nasdaq 100 remains more than 25% higher this year, the buy-at-all-costs spirit that drove the rally is starting to fizzle as investors question sky-high valuations against a backdrop of climbing coronavirus cases. With fears of further economic pain growing, pressure is rising on tech companies to deliver the profit growth needed to justify their lofty price-tags. With U.S. presidential election on Nov. 3 and concerns that a Democratic sweep could bring higher taxes and increased regulatory scrutiny, this week’s earnings showing wasn’t enough to assuage the market’s nerves.’
Please excuse the tired analogy, but over the past few months the markets have seemed to be in a bit of a Schrodinger’s Cat situation regarding the prospects of another COVID-19 wave, contested elections, and economic fallout from further COVID-19 lockdowns. For a quick recap of what Schrodinger’s Cat means:
‘In simple terms, Schrödinger stated that if you place a cat and something that could kill the cat (a radioactive atom) in a box and sealed it, you would not know if the cat was dead or alive until you opened the box, so that until the box was opened, the cat was (in a sense) both “dead and alive”.’
Said differently, in a situation with heightened levels of uncertainty due to lack of information or insight (box is closed) it is possible for two opposing states to exist – one where the cat had been killed by the device, and one where the cat survived. Who is to say until the box is opened?
I use this analogy because in 2020 it is virtually impossible to have any certainty around how the future will unfold in the short to medium term. That said, this type of environment is conducive to the wild swings experienced in markets this year full of rapid bear markets, bull market rallies, corrections, and everything of the sort. In this case, Schrodinger’s Cat is the stock market, and the device(s) placed in the box are obvious: COVID-19, contested election, stimulus, etc. Just think about how much speculation and commentary there has been about the short and long term economic consequences of COVID since the pandemic first truly gripped the US in March.
We started talking about the dreaded additional ‘wave’ of COVID in the fall before we had even finished dealing with the first wave. Yet, over the summer months we saw a boom in speculative behavior best exemplified by the influx of retail day traders on TikTok. Again, this is because up until very recently there was still enough uncertainty surrounding the prospects of a Fall wave that there could be both a future in which we avoided such a wave and continued the economic recovery, or one where our worst fears are realized. The existence of both futures allowed for a boom in speculation.
While Schrodinger’s box was not necessarily opened over the last week, we definitely snuck a cheeky glance inside and did not like what we saw. The reality of a fiercely contested election on Tuesday is concerning enough, but the rise in record COVID-19 cases around the world is only exacerbating matters. News only got worse over the weekend as Prime Minister Boris Johnson announced a second lockdown across the UK that will last until December.
In tandem with the daunting reality of Schrodinger’s Box finally being opened is the role of “TINA” (there is no alternative) for growth stocks. As OSAM Research Partner Jesse Livermore (pseudonym) recently wrote:
‘If investors are sensitive to valuation, rising prices will reduce their desire to allocate to equities. But it’s difficult for valuation to gain traction as a consideration in the current environment. The relevant value proposition that investors have to consider is an awkward proposition that pits positive-but-historically-depressed earnings yields in equities against zero yields in everything else. Rising equity valuations cannot easily shift the balance of that proposition for at least two reasons. First, equities can produce attractive returns even when purchased at elevated valuations, provided that they stay at those valuations—and in the current case, they very well might. Second, the alternative proposition—earning a negative real return for an indefinite period of time while others continue to make money–is simply unacceptable to many investors.
We refer to this logic as the logic of TINA—”There is No Alternative.” The logic is sound, but it has limitations. Equities aren’t going to rise to infinity—an earnings yield of zero–simply because the competition is yielding zero. As equities become more expensive, they become more “needy”, more sensitive to declines in buyer enthusiasm. Their neediness and dependence on continued buyer enthusiasm increases their potential for inflicting losses.
To illustrate, imagine that you are in a two-asset market where one asset, cash, earns nothing forever, and the other asset, an equity stream, earns $1 a year forever, with a portion of that amount paid out as a dividend and a portion reinvested to generate future growth. If you buy the equity stream for $10—an earnings yield of 10%—and the enthusiasm of buyers subsequently wanes, you won’t need to sell at a loss. If the price falls, it’s not a big deal, because the 10% yield that you be will earning on the investment is intrinsically worth the temporary loss of access to your money. All you will have to do is wait and let the earnings accumulate, either as dividends that get paid out to you or as investments that compound. Over the long-term, you will end up doing very well, regardless of where the market decides to take the price.
But now suppose that the price gets pushed up in a TINA chase to $100—an earnings yield of 1%. If you buy at that price, you’re going to have to remain laser-focused on the market’s subsequent response, keeping the position on a short leash and rapidly exiting if buyer enthusiasm starts to wane, because the 1% earnings yield that you’re going to be accruing is nowhere near enough to compensate you for the loss of access to your money, which is what you will have to endure if the price falls appreciably from where it currently is. If the market decides that it wants to assign a 20 P/E ratio to the security instead of a 100 P/E ratio, the price is going to fall by 80%. You’re going to have to wait a full 80 years to get your money back in earnings. Will the wait be worth the 1% spread over cash that you will have locked in? Absolutely not, which is why you’re going to have to pay close attention and make sure that you don’t get stuck in that kind of a situation.
In the same way that you are going to be more sensitive to drawdown risk as a buyer at elevated valuations, everyone else in the market is going to be more sensitive as well, which will make the prices themselves more sensitive, and the investments more risky.’
Interestingly, this TINA concept was written about as far back as 1688:
We saw some of this dynamic play out in markets this week as many of the big tech companies that reported earnings actually posted impressive figures, but endured substantial losses in the market as investors’ lofty expectations were not met. Every one of the FAAMG stocks beat their profit estimates handedly, but all suffered weekly declines nonetheless. With such expensive valuations, and the prospect of Schrodinger’s box being opened only to a morbid discovery, these high flying growth stocks seem vulnerable.
All this to say that today’s post will attempt to provide historical context for investors on some of the major topics surrounding markets following this week’s decline. We still do not know what we’ll find in Schrodinger’s box, but we can try to form an educated guess. Let’s dive in!
Well it’s finally here, so let us take one last look at the financial / economic history surrounding elections. This paper analyzes almost 200 years of data to study the relationship between elections and the U.S. economy:
‘The influence of the economy on presidential elections has been well documented. However, citing the substantial growth of the federal government and the enactment of legislation such as the Employment Act of 1946, the majority of the literature focuses on the effect of the economy only on modern presidents. While some scholars study the influence of the economy on presidents starting in 1913 or even the late nineteenth century, few, if any, scholars study the effect of the economy on earlier presidents.
This paper examines the extent to which the U.S. economy affected presidential election from the early 19th century to the present day. Arguing that the federal government’s role in the national economy changed dramatically during the middle of the twentieth century, we present evidence that price stability was positively associated with incumbent party electoral success from 1828 to 1948 and that income growth was directly related to incumbent party electoral success in the subsequent years. While the nature of the economic effects on presidential elections have varied over time, economic conditions have clearly played a role in national elections since the early years of the American republic.‘
Interestingly, the evolving role of the Federal Reserve suggests that there may have been a shift in exactly what evidence supported a ‘strong economy’, and how this helped/hurt the incumbent during elections:
‘Though the Federal Reserve System was established in 1913, it did not enjoy its current level of policymaking independence until the Accord with the Treasury Department in 1951 . Prior to the Accord, the Federal Reserve helped to keep interest rates low in order to support government bond prices as was desired by the Treasury Department. However, after the war, inflation began to increase and the Federal Reserve‘s purchase of Treasury issues to maintain government bond prices led to more inflation… In other words, the operation of the Federal Reserve was no longer fully tied with the goals of the Treasury. Thus, until 1952, the executive branch had significantly more control over monetary policy—and the value of the currency—than it did following the Accord.‘
Therefore, there seem to be two separate periods worth studying: Pre-1952 and Post-1952.
‘The concomitant transformation of the position of the federal government in the national economy and the increase in the independence of the Federal Reserve suggests the following hypotheses related to the role of economic circumstances in presidential elections:
- Prior to 1952, price stability was positively associated with the share of the vote received by the incumbent president (or his fellow partisan).
- From 1952 to the present, income growth was positively associated with the share of the vote received by the incumbent president (or his fellow partisan).’
The findings in this paper largely support these two hypotheses.
‘Everyone hates COVID-19 and the way it has disrupted our lives. The COVID pandemic has shut down the world and led to the layoff of millions of workers. Unemployment has soared, GDP has declined, and businesses have gone bankrupt. With winter arriving in the northern hemisphere, COVID cases are likely to increase. The main consolation is that a vaccine is on the way, and once it is available, life can hopefully return to the pre-pandemic “normal” which we all enjoyed.
Or will this be the COVID Decade? Will we be fighting COVID-19 not for the next year, but for the next decade? Will there be other corona-related viruses which may be even worse than COVID-19? Will the COVID-19 virus evolve and make the vaccines which are being developed useless causing reinfections? Will we be wearing masks and social distancing for the rest of the decade, or our lives? Will we be unable to go to concerts and theaters and conventions for the next ten years? Will the government maintain a closed 90% economy to “protect” us for the rest of the decade? Although few people are anticipating this, we may be facing a COVID decade, not a COVID year.’
‘The article considers crises of globalization: the 1840s, the 1870s, the Great War, the Great Depression, the Great Inflation (1970s), the Global Financial Crisis (2008) and the Great Lockdown (2020). Each led to a reshaping of the institutions that supervised or regulated economic development globally but also nationally. In each case, a series of questions are answered: what were the origins of the crisis, what were the monetary and fiscal policy responses, how did the crisis affect the drivers of globalization, trade, migration and capital flows? And how did these different challenges affect governance and views of politics? The article concludes that supply shocks are most easily dealt with by inflationary mechanisms, allowing groups to gain some apparent compensation for their losses through the supply shock. But the resulting mobilization into groups also strains social cohesion.’
‘This paper investigates how state-level characteristics in demographics, economic structure, and nonpharmaceutical interventions (NPIs, the equivalent to today’s shelter-in-place, quarantine, and social distancing measures) impacted tax revenues during the 1918 Influenza in the U.S. Following Correia et al. (2020), Lilley et al. (2020), Goolsbee and Syverson (2020), and Serrato and Zidar (2018), I estimate two difference in differences models with panel data using various ways of constructing treatment and control groups. I also run a cross sectional analysis incorporating more time-invariant variables.
The main preliminary results from the diff-in-diff models are that the intensity of NPI policies seemed to have more dramatic impacts on tax revenue growth than the adoption speed of NPI. As a treatment factor, higher NPI intensity tended to depress tax revenues, especially corporate tax growth rate. Faster speed NPI implementation led to higher corporate tax growth rate than otherwise. Personal tax and total tax did not seem to have been impacted as dramatically as corporate tax. By creating treatment and control groups based on whether a state had neighbors enacting more intense NPI policies, I observe that treatment states were more likely to also have more intense NPI measures “under peer pressure.” However, there were no significant differences in tax revenue growth between the treatment and control group states. When examining cumulative growth rates from 1918 to 1925, I find that tax revenue growth was mostly driven by the expansion of tax base, both in terms of number of tax returns and amount of net income available for revenue collection, rather than by geographical or demographic factors. The intensity or speed of NPI measures and the mortality rate during the pandemic likely did not have a persistent impact on tax revenue growth when considered over a medium-term (seven-year) window.’
The slides for a presentation I gave last week on the noticeable patterns that repeat themselves over the course of centuries. When the video is up I will share!
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