The Future of Bear Markets & Recessions

In 1939, Albert Einstein wrote a letter to Franklin D. Roosevelt warning him the Nazis could be developing atomic weapons. Einstein urged the president to begin work on our own nuclear weapons.

Six short years later the Manhattan Project made these weapons a reality, first with a successful test in New Mexico in the summer of 1945. A month later two atomic bombs were dropped on Japan, accelerating the end of the second world war.

Dan Carlin explored the morality of this decision in his book The End is Always Near:

The truth is, the decision makers almost certainly didn’t have the range of options we often assume (or wish) they had. The idea that President Truman could have done something other than use the atomic bomb on Japan is probably a little out of step with the political realities of the time. As the historian Garry Wills wrote in his book Bomb Power: “If it became known that the United States had a knockout weapon it did not use, the families of any Americans killed after the development of the bomb would be furious. The public, the press, and Congress would turn on the President and his advisors. There would have been a cry to impeach President Truman and court-martial General Groves. The administration would be convicted of spending billions of dollars and draining massive amounts of brain power and manpower from other war projects and all for nothing.”

I can’t imagine what it was like to make that decision.

Two decades later an NBC news documentary called The Decision to Drop the Bomb interviewed the architect of the atomic bomb, J. Robert Oppenheimer. He described the scene following the decision to use these weapons of mass destruction:

We knew the world would not be the same. A few people laughed. A few people cried. Most people were silent. I remembered the line from the end of scripture, the Bhagavad Gita. Vishnu is trying to persuade the prince that he should do his duty and, to impress him, takes on his multiarmed form and says, ‘Now, I am become death, the destroyer of worlds.’ I suppose we all thought that one way or another.

These bombs haven’t been used in a war setting ever since but Carlin assumes it will be difficult to avoid, writing, “Unless humankind can break patterns of collective behavior that are older than history itself, we can expect to have a full-scale nuclear war at some point in our future.”

You can’t stuff that genie back in the bottle once it’s out.

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This may be a bit of hyperbole, but the U.S. government now has a weapon to fight economic downturns and the American people are going to be angry if they don’t use it during future downturns.

This week a podcast listener asked the following related question:

If you have a longer time horizon and we think long-term recessions in the stock market are to some extent a relic of the past due to new Fed interventions in times of trouble, why invest in bonds at all? Wouldn’t the bounceback of stocks outweigh any loss savings on the downswing by holding bonds?

I feel like the only way to make bonds work in that new normal would be to time the market which is a universal no-no. Interested to hear your take on those two together.

I certainly don’t think recessions are a relic of the past due to Fed intervention. There will definitely be recessions in the future.

But could they become more muted? I think it’s a possibility. Now that we’ve seen the immense power of government spending during a crashing economy, there is no going back, for better or worse.

It’s impossible to predict how much spending will be used in the future because politics are involved in this process. Politics are probably even harder to predict than the markets. However, now that people have received those checks you better believe they will ask their elected officials for them the next time a downturn hits.

Here are some of the biggest ramifications I could see transpiring from a world with more powerful fiscal and monetary policy:

Markets that move faster. The stock market went from an all-time high last February to a 34% bear market in just 23 trading days. We were back to new highs less than 5 months later.

Consider the fact that last April the price of oil went to negative $37 a barrel.1 People were literally paying you to take oil off your hands. A little more than a year later oil prices are in the high $60s and the southeast is experiencing a gas shortage.

Markets are moving faster than ever because of advances in technology but fiscal intervention from government officials will speed things up even more. Investors will be trying to get ahead of this stuff now.

If you know the government will send out checks and increase unemployment insurance, won’t investors buy much sooner during a market sell-off?

And if we get too much spending and higher inflation is on the table, won’t investors be quicker to sell during a bull market?

I think increased government spending could actually lead to more corrections and bear markets, they just might be shorter in duration and smaller in magnitude.

More flash crashes. Stability breeds instability and risk-taking will likely increase because of the government’s actions during the pandemic. If you know the government is going to take the possibility of depressions and severe recessions off the table, why would you wait for severely distressed prices that may never show up?

Market moves will be even more magnified than in the past. If investors decide to take more risk in a world that seemingly has fewer macro risks we could see new market risks pop up. Pockets of liquidity could enter the market or dry up in a hurry causing massive swings in both directions.

Don’t be surprised if we see more short-term flash crashes in the years ahead.

More volatility in everything. If the economic environment following the Great Recession was categorized as slow and steady, the recovery following the Corona Crash is fast and volatile.

Investors, economists and politicians alike have no experience dealing with the implications of higher government spending. This is likely to bring about more volatility in, frankly, everything.

More volatility in the markets. More volatility in the economy. More volatility in earnings numbers. More volatility in economic data. More volatility in investor reactions.

Not better or worse per se but more volatile in many ways.

Simplicity matters more than ever. Markets and macro are probably more complex than they’ve been in some time, maybe ever. You may conclude this requires your portfolio to become more complicated but I think the opposite is true.

When things get crazy simple is better than complex. Simple is easier to understand. It helps reduce FOMO. It makes it easier to focus on what you can control.

And it reduces the potential for avoidable and unnecessary mistakes.

Michael and I tackled this question (at the very end of this video) and more on this week’s Animal Spirits:

Subscribe to The Compound for more of these videos.

Further Reading:
My New Theory About Future Stock Market Returns

1I still can’t believe this happened.

 
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