Things seem eerily familiar in today’s financial markets

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All too often, people go through life without contemplating that some things could turn out less than ideally. That affliction is called optimism bias, and is one of many biases we humans are prone to when it comes to investing. People often think long-term historical averages are reasonable expectations for what they will encounter in the future. Indeed, in the very long run, they’re not likely to be off by a lot. However, in short- to medium-term intervals, the experience may be quite different.

Long-run averages are nothing more than a series of short- and medium-run averages strung together. One example of how things might not go very well is what happened in Japan in the late 1980s. Valuations became extremely stretched and stock markets hit all-time highs by the end of the decade. Then the decline started. As of now, the Japanese stock market has still not regained the highs that were reached on Dec. 31, 1989. That’s a full third of a century of negative aggregate returns. When it comes to looking at what we might reasonably expect in the future, an experience akin to what the Japanese investors encountered is unlikely. However, that does not mean long-term experiences might not be middling nonetheless.

Even in North America, there have been several instances where we have endured a “lost decade.” It may well be that another such lost decade is again upon us – having started in January of 2022. The reason I say this is because there are several risks baked into the prices of securities today that are likely to have a negative impact on the medium-term future. For context, let’s look at the three biggest negative impacts of the past half century.

First, in 1974, North American markets dropped by more than 40 per cent in the aftermath of the OPEC-induced oil crisis and the resulting episode of stagflation. Today, the risk of stagflation is higher than it has been at any time since 1974 because of demographics, trade wars, the need to aggressively reduce carbon emissions and job losses owing to artificial intelligence. You already know about the continuing challenge of inflation.

The second major negative impact was at the turn of the millennium, when valuations such as the cyclically adjusted price earnings (CAPE) ratio hit all-time highs for North American stocks. High CAPE matters because it is a highly reliable harbinger of poor returns when the number becomes inflated. Going back to January of 2022, the CAPE ratio for North American stocks was the highest ever, save for the dot-com bubble. And when that bubble burst, stocks dropped by between 50 per cent and 60 per cent.

Finally, most people will vividly remember the global financial crisis of 2007 to 2009. In that instance, the world experienced a severe credit bubble that led to – among other things – wildly overpriced real estate. Once again, history seems to be repeating itself and there is a strong consensus that we are now in the largest credit bubble since the financial crisis. Again, the negative impact during that period was well over 50 per cent.

Here we have three instances in the past half century where the market has seen a significant negative impact; we now are experiencing an environment that is very likely the worst since then. It would be difficult to imagine how we could get through all three of these challenges (stagflation, high valuations, and a credit bubble) without having a severe adverse consequence. Any one of them could severely derail the economy. Now, we’re dealing with all three simultaneously.

Optimism bias – something I like to call “bullshift” – is a strange affliction. It involves people believing bad things will happen to others, but not to them. Many people are currently investing as though they will not experience a severe market downturn and, as a result, may well be whistling past the graveyard when it comes to their own portfolio. That is not to say people should run for the hills. However, it does mean people must reflect carefully on their true risk tolerance and adjust holdings if needed. It’s better to make purposeful decisions when the problem is merely hypothetical than to make reactionary decisions when the problem becomes real – and highly emotional.

John De Goey is a portfolio manager with Designed Securities Ltd. (DSL). DSL does not guarantee the accuracy or completeness of the information contained herein, nor does DSL assume any liability for any loss that may result from the reliance by any person upon any such information or opinions.

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