A World of Divergences

May 18, 2022

Buying the Dip has been a fantastic route to investment success for decades. It may work again, but the odds are against it. Over the past few weeks I have spoken at length with investment professionals, private traders/investors, and family members, most of them not having a clue that I research and write about these topics constantly. The common thesis is that this will pass and just keep buying the dips.

It is important to recognize that this methodology has worked for many decades and has made almost everyone who used a consistent and well thought out plan to buy and hold investments for the long term wealthier. In fact, much wealthier.

Using this backdrop it is very difficult to explain that the reason for their success has nothing to do with their strategy (the professionals), their investing acumen (the private traders and self investors) or their hard work and diligence (family). Those things are prerequisites to financial success, but even a monkey could have bought the S&P500 or TSX and made a killing using that one strategy, a consistent investment plan and no acumen was necessary. Below is a monthly chart of the S&P 500 since 1980. On a monthly basis, there have only been four very brief periods where the S&P 500 dropped below the 50 month trend line. They include:

  • The dot com bust in 2001-2002
  • The housing collapse of 2008-2009
  • The downgrade of US sovereign debt in 2011
  • COVID Crash of 2020

People are often scared by these sharp moves and they stick in their minds, but what may not be so sticky are the benefits that have made for the constant rise in equity prices possible. There are far too many of them to make a reasonable list, but here are a few that are pertinent.

1 – Taxes keep going down. In 1981, President Reagan reduced taxes on top earners from 70% to 50% and at the low end from 14% to 11%. Taxes had been as high as 90% in the 1940’s and 1950’s to help pay for the war(s) effort, and the reductions were an attempt to revive growth. Here is a visual history of top tax rates in the USA and below that, corporate tax rates.

Personal Tax Rates
US Corporate Tax Rates

2 – Profiting from business became an increasingly significant focus. There were many aspects of this that became important, such as businesses incorporated to get better tax treatment, (including lower tax rates, better deductions and reduced liability) but also size being a key factor in lowering costs and increasing power. Over the past three decades, this has caused a wave of acquisitions and consolidations which have, arguably, limited competition and increased profitability. Here is a chart of the profitability (in total dollars) of US Corporations.

Profits of US Corporations over time

3 – Reducing risks and costs became a focus. During President Clinton’s first term, the efforts to increase globalization and lift other countries out of poverty was a core focus. One benefit, whether it was clear or not was that by opening markets to China (primarily), India and others, the ability to rely on cheap labor was now a focal point for corporations to increase profits. Here is a chart showing how much the US buys from China vs. how much China buys from the USA. Clinton’s efforts in the late 1990’s led to China joining the WTO and corporations the world over began shipping jobs to China.

Looking for a way to show this quickly is a bit difficult, but here is a chart contained in a US government report from 2015. The chart shows how quickly foreign investment grew in the years after their inclusion in the WTO.

Without context it may seem trivial, but the essence is that corporations around the world eliminated cost and risk by moving manufacturing and service jobs off shore, and not just to China, India, Japan. Anywhere really. To boost productivity and profits.

4 – Finally there was automation and innovation. The scale of innovation that began in the late 1980’s with the advent of computers, drugs, materials and some other innovations overwhelmed ‘old’ ways and unleashed a torrent of growth.

5 – None of this works without the magic elixir that is money. A chart that I have posted before is shown here again, and that is the growth of money in the US. This chart will be similar for most first world countries as the world’s largest central banks have flooded their markets with money. In the chart below, the yellow line is the S&P 500, the green line is the M1 money supply and the black line is the federal funds rate.

The important bits of this show that every time there is a threat of negative growth, the central bank either lowers interest rates, or increases the money supply or both. During the COVID crash of 2020, both were used to MASSIVE effect, and asset prices were saved while government debt soared. It caused a dramatic effect, lifting all asset prices.

Where does all of this leave us? We are now, metaphorically, on the other side of that mountain. Interest rates cannot go any lower, taxes are at unsustainable lows, particularly for corporations, and globalization is strained. US Government debt has tripled since the housing crisis of 2008-2009 and while debt ceilings are ever increasing, the risk of defaults elsewhere are also increasing.

Put another way, divergences are appearing everywhere all at once.

At the same time, environmental disasters seem to be increasing and pressure is rising to act to prevent a variety of disasters. War has broken out in Eastern Europe and there remains plenty of sabre rattling in other parts of the world.

So why be bullish on markets? Recent history (5-20 years) suggests the glory days will continue but the above list of serious macro economic factors suggest exactly the opposite. Over the past four decades, governments, corporations and people have monetized everything, sucked out about all of the excess available from every situation and there is little or no room for an error.

Despite this, the number of ‘random’, ‘act of god’ or ‘once in a lifetime’ events that are upsetting the world view of ‘normal’ is rising rapidly. There are real costs to wars, natural disasters and pandemics (among other things) and they are poorly accounted for today.

The risk of unexpected negative events overwhelming the status quo is therefore much higher than normal and asset prices in almost every market are based on a world that is full of optimism and indifference to the real costs that are prevalent in a normal society, let alone one that faces substantial risk.

These benefits have reached their limit and a reversal seems likely. For that reason buying the dip should probably be avoided unless you are a nimble trader. There will almost certainly be a better time to invest and a better price to acquire assets.

For those that do trade, yesterday’s market bounce (90 point gain) has given way to today’s market slaughter (150 point decline) as the news about a new reality becomes clearer.

[what news? Federal Reserve reiterates they will not hesitate to continue hiking rates until inflation is under control. Reports by some of the largest retailers including Walmart, Target, Home Depot, Lowes suggest inflation is rampant and will last a while at the same time as spending is being hurt by rising prices. All this while there are reports of serious issues with food supply, water supply and an ongoing war. But beyond that everything should be just fine.]

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