We, like many, thought a Trump presidency would make markets jittery, but the lack of stock market volatility in 2017 was astounding. In an average year, the stock market has an average max loss of ~14%. In 2017, the greatest draw-down was ~3%! In our eyes, this indicates a tremendous amount of complacency and a market ripe for disruption. Understanding why the market is so complacent can help us understand when and how future volatility can impact our portfolios.
A core tenet of our investment philosophy comes from the economist Hyman Minsky, who stated “stability begets instability.” In economic terms, as the good times roll, more credit is extended at easier terms and to more suspect borrowers until too much credit is extended and the debt cannot be repaid. There was no better example of this than the Global Financial Crisis of 2007-2009. A lack of volatility is a sign of complacency, which we believe is caused by two factors – a market focused on the actions of the Central Banks, believing them to be omnipotent, and the rise of passive investing leading to the under analysis of the risks of securities.
One economic model used by the Central Banks ignored the entire banking system, completely missing the financial crisis of 2007-2009. Since the financial crisis, Central Banks have purchased large quantities of financial assets, driving interest rates and volatility to some of the lowest levels in history. They have engineered the perfect conditions for growth, but growth has been lacking. As a country, we have done a tremendous job growing our economy, but since the financial crisis we have deviated greatly from the trend shown in this chart1. If we were to get back to the trend growth line, our economy would be about $3 trillion bigger – which would go a long way in solving many of our economic problems.
As we have deviated from the long-term growth trendline, we have increased our debt burden at an astonishing rate. To the right is a chart2 illustrating nominal GDP (the size of our economy) versus the amount of corporate debt outstanding. As we can see, it takes more and more debt to support one dollar of economic output.
This article was featured in the 2017-2018 Ganim Financial Annual Report. Read the full article here.