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The Link Between Main Street and Wall Street

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The Link Between Main Street and Wall Street WHAT’S PAST IS PROLOGUE: THE MARKETS AND ECONOMY IN 2019 2018 marked the first time since the global financial The Link Between Main Street and crisis that the U.S. equity market posted a negative re- turn for a calendar year. After hitting an all-time high Wall Street in late September, the market traded lower through- The lifeblood of financial markets is the real econo- out the fourth quarter, punctuated by a record decline my. What happens on Main Street determines what of 2.7% on Christmas Eve. Analysts were quick to happens on Wall Street, although this causality re- blame the sell-off on a variety of reasons: fears that verses from time to time, such as during the global the Federal Reserve was raising interest rates too financial crisis. In the long run, however, economic rapidly, concerns over escalating trade conflicts with activity generates corporate revenues and corporate China, anxiety about slowing economic activity, profits, which in turn enables investors to place val- the looming government shutdown and so forth. ues on financial assets such as stocks and bonds. As Volatility spiked, and at year-end, pundits were quick the nearby graph illustrates, over longer periods of to declare the end of the bull market, with a recession time, the growth in these three variables – nominal Author almost certain to follow. gross domestic product (GDP), corporate earnings and stock prices – is remarkably similar, although the As the calendar turned to 2019, equity investors wel- volatility of this growth is vastly different. comed a recovery in stock prices. Yet the bounce leaves many investors slightly uneasy and suspi- GDP, Corporate Earnings and Equity Values cious that the worst may not be past. We readily 80% G. Scott Clemons, CFA acknowledge that our crystal ball is no clearer than Chief Investment Strategist 60% anyone else’s, and so we turn to history for insight Corporate Nominal GDP Growth (yoy) @GSClemons into what is likely to follow. In the pages that follow, 40% we put recent market developments into context, in 20% 7.4% average acknowledgment of Antonio’s observation in Act 2 of 6.4% average 0% William Shakespeare’s “The Tempest,” that “what’s 8.6% average Nominal GDP Growth past is prologue.” We can’t predict, but we can pre- -20% S&P 500 Change (yoy) pare, and history offers a guide. -40% Source: Bureau of Economic Analysis, Standard & Poor’s and BBH Analysis. Data as of January 30, 2019. -60% 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 1 Brown Brothers Harriman Quarterly Investment Journal InvestorView Nominal GDP (real GDP plus inflation) has expanded at an The point of this brief analysis is annual rate of 6.4% over the past 60 years, with a standard de- viation of 3.0%. This means that roughly two-thirds of the time, that price volatility is a feature of our nominal GDP has grown between 3.4% and 9.4%. Corporate earnings have expanded at an annualized pace of 7.4% over economic system, not a bug. Since the same period, a slightly better growth rate due to gains in productivity. Yet the volatility here is almost five times that of the S&P 500’s creation in 1928, the the underlying economy, reflecting cycles in corporate profit margins. When margins are rising, economic activity is mag- market has experienced an average nified in corporate earnings, and when margins are falling, the translation is diminished. of 17 days per year in which the in- A similar amplification takes place when corporate earnings dex moved by 2% or more in a single translate into stock prices. The added dynamic here is the valuation cycle, which depends on interest rates and investor trading session. In 2018, the market sentiment, among a host of other influences. At different points in the past, the stock market has valued a dollar of earnings (as experienced 20 days with this level of measured by the price-to-earnings ratio, or PE) anywhere from $7 in the late 1970s to almost $30 at the peak of the 1990s volatility – right in line with the his- dot-com bubble. The average return of the equity market over torical average.” this same period is similar to economic and corporate earnings growth, at 8.6%, but with even more volatility. The point of this brief analysis is that price volatility is a feature of our economic system, not a bug. Since the S&P 500’s creation in 1928, the market has experienced an average of 17 days per year in which the index moved by 2% or more in a single trading CBOE Volatility Index (VIX) session. In 2018, the market experienced 20 days with this level 90 of volatility – right in line with the historical average. In 2017, Financial crisis 80 however, the market had zero 2% trading days, only the 10th year in the past century without a single day of exaggerated 70 volatility. Volatility is normal. Stability is abnormal. 60 50 Flash crash U.S. debt downgrade The CBOE Volatility Index (VIX) offers a more sophisticated Chinese growth concerns U.S. growth 40 concerns measure of volatility by aggregating the implied volatility of 30 every stock option that trades on the Chicago Board Options Exchange. The price of an individual stock option requires mul- 20 tiple inputs, including the current price of the stock, the strike 10 Source: Chicago Board Options Exchange and BBH Analysis. Data as of January 30, 2019. price of the option, time left to the expiration of the option and 0 the expected volatility of the underlying stock. If we know all 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 the variables but one (volatility, for example), we can solve for it. The VIX does precisely this for the overall equity market. It is, however, intellectually spurious to assign cause and effect to these volatility surges, although the labels on our graph do The nearby graph shows the VIX for the past 15 years and precisely that. In the same way that Sherlock Holmes found reveals that the Christmas Eve spike in volatility, while rare, curious evidence in the dog that did not bark in “The Adventure is not unique. The index has risen above 35 on six separate of Silver Blaze,” there are plenty of dogs that are not barking occasions over this period, corresponding to pronounced mar- in this graph of market volatility. There are, for example, no ket developments, from the onset of the financial crisis, to the volatility spikes labeled “trade disputes” or “Brexit,” although downgrade of the U.S. debt rating, to the occasional elevation both developments pose potential threats to the economy and in fears about economic growth at home or abroad. financial markets. These “dogs that do not bark” should prompt us to exercise caution when assigning cause to market action. Brown Brothers Harriman Quarterly Investment Journal 2 It is, in fact, a product of hindsight bias that there are labels on prices over the next few days, weeks and months. The good this graph at all. It is human nature to want our effects to have news is that once the system shifts it is in a much more resilient causes, and in retrospect it is easy to assign blame for spikes in state. Criticality may start rising again right away, but the reset market volatility. The reality is that market moves often have makes the system healthier for a period of time. more to say about the internal state of the market than about external influences. Let us return once again to history as both a guide to and justifi- cation of this analogy. The VIX has risen above 35 only 12 times Consider the following analogy. If we were to slowly build a pile since the creation of the index in 1990, including last Christmas of sand one grain at a time, a predictable shape would eventually Eve. As the nearby table illustrates, equity prices often remain emerge. At some point, one additional grain of sand, however, under pressure for a few weeks following the spike in volatility. would cause the whole pile to shift. We would stop and wonder One month out, the market remained in negative territory in why the pile shifted, and as tempting as it would be to blame half of our historical examples, for an average return of -0.7%. the last grain of sand that we dropped, the last grain was no Further out, however, returns have historically improved, so different from all the grains that had come before. In reality, that by a full year later eight out of 10 periods enjoyed positive the pile shifted because it was in a critical state in which it was and even double-digit rebounds. prone to overreact to external factors, even if that last factor was no different from what came before. Equity Market Responses to VIX Spikes > 35 Date +1 month +3 months +6 months +1 year 8/6/1990 -5.6% -7.9% 3.8% 15.6% 1/14/1991 17.5% 20.7% 21.5% 35.7% 10/30/1997 3.7% 7.6% 20.0% 20.0% 8/27/1998 -3.7% 9.9% 15.7% 27.3% 9/17/2001 0.6% 3.2% 6.3% -17.2% 7/15/2002 0.0% -8.3% 2.0% 10.9% 9/17/2008 -22.0% -24.4% -36.7% -9.4% 5/7/2010 -5.2% 0.1% 9.5% 21.3% 8/8/2011 0.2% 5.9% 13.7% 19.6% 8/24/2015 -1.4% 6.7% -1.3% 13.7% 2/5/2018 -2.0% -3.9% 4.2% ? 12/24/2018 10.1% ? ? ? Now consider the parallel to fourth quarter 2018.
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