“Those who cannot remember the past are condemned to repeat it.”
– George Santayana, The Life of Reason
“I’ve got news for Mr. Santayana: we’re doomed to repeat the past no matter what. That’s what it is to be alive.”
– Kurt Vonnegut, Bluebeard
“What’s past is prologue.”
– William Shakespeare, The Tempest
“Past performance is not indicative of future results.”
– Every investment manager ever, SEC-mandated disclosures
So… who is right? Can we learn from history, as Santayana believes? Or has the past just set the table for what’s to come, as Shakespeare wrote? Is the future determined by the past, as Vonnegut argues? Or are the two unrelated, as the SEC requires fund managers to tell their prospective investors? We suggest that the answer to all of these questions is yes.
It’s 2010 All Over Again
The country is in the middle of recovering from a steep economic decline. There is a clear difference between Wall Street and Main Street, with many citizens struggling from the aftermath of the crisis while those who had the opportunity to invest during the market dislocation have been more fortunate. Financial markets have largely recovered from the lows even as many investors warn that the market fundamentals and weak economy do not justify such a quick recovery. Meanwhile, the Federal Reserve has lowered its target Fed Funds rate to near zero, flooding the markets with free money, with both commendable and unintended consequences: commendable in attempting to use monetary policy levers to shore up key aspects of the financial system in need of fiscal policy help; unintended in propping up fundamentally-uncertain markets by enabling an unprecedented access to leverage.
In 2020, the COVID-19 global pandemic has led to these circumstances and more. In 2010, it was the Great Recession, with the market dislocation of 2008 still very much front-of-mind for the vast majority of the population. Of course, given the PTSD still present in many investors who were involved in the markets at that time, we are certainly not the first to draw this parallel. Indeed, such comparisons have become trite and can be oversimplifying. But there are a few observations, further illustrated by the charts below, that are nevertheless worth highlighting:
- In 2010, the high yield market was even more robust than equities at the outset of the economic recovery.
This might be explained by both caution and growth. On the one hand, high yield bonds are debt instruments which sit higher up in the capital structure, and they pay healthy coupons that offset price declines when considering total return. A cautiously optimistic investor who wants to take advantage of the high correlation between all asset classes in a dislocation could potentially find more attractive risk/reward in the bond markets. But within the bond markets, high yield bonds tend to perform better than investment grade bonds after the economy has been beaten down and rates are low. This is because economic improvement tends to compress credit spreads and raise interest rates. Since the high yield market tends to have, on average, shorter maturities and wider credit spreads than the investment grade market, both of these factors work in favor of high yield as the country looks to recover from the economic downturn, whether in 2010 or 2020.
- The 2010 market recovery wasn’t without corrections along the way.
Most notable after the Great Recession was the market reset that took place in 2011. There was another smaller decline in mid-2010, which may be compared to the wobble in the markets in June/July this past summer. In our view, the risk of corrections is directly tied to the mismatch between market strength and fundamental uncertainty. Valuations in the marketplace tend to reflect projections built on top of fundamentals, either current or prospective. It is safe to say that in the current environment, the expectations built into the market are projections built on top of prospective fundamentals. So if results during an earnings season collectively disappoint versus the prospective fundamentals that underlie a projection, the risk of a correction increases. And if the results or market sentiments cast doubt on the assumptions that underlie the projections themselves, then the risk of a correction increases further. Collectively, we may find that at least some of the observed market gains are spurred not just by hope but by hope squared.
- The markets in 2009 took nearly a full year to get close to recovering to pre-dislocation levels. In 2020, it took less than six months.
This observation is notable because the timeline of seemingly parallel events in two different periods is never the same. Why? Because, despite some evidence to the contrary, market participants do tend to learn from the past; or maybe more accurately, they tend to adjust future behavior based on their past experiences. In 2020, the markets recovered much more quickly than they did during the 2008/2009 decline. We believe this is because investors have learned over the last decade not to be skeptical of support from the Federal Reserve. But investors have let their good fortune cloud the risk that the entire timeline might be compressed. That includes the potential for further corrections. We believe, for many reasons, that we are likely to see more frequent corrections than we did during the Great Recession and that many market participants are much too complacent about the timeframe.