Bear markets are punishment for over-exuberance and greed, notes ConvergEx's Nick Colas, teaching investors to be more careful next time around. That’s a pretty popular narrative in capital markets, and with two tough bear markets over the past 15 years, Colas suggests you’d think that there’s no way investors would be guilty of blowing bubbles again. Right? Well, as Nick explains, if the evidence from actual crime and punishment is any guide, this moral narrative is actually quite wrong.
Via ConvergEx's Nick Colas,
Recidivism – the percent of criminals who are rearrested after a stint in prison - is +40% across the U.S. and over 50% in some states like California. Those ‘Scared Straight’ programs you see on reality TV? Many criminal psychologists think they do more harm than good, and the data supports that point of view. So despite lifting equities to unsustainable levels twice in a generation, investors are perfectly capable of doing it again. Let the punishment fit the crime if this is the case.
The current generation of investors must be the most bubble-conscious market participants since the Dutch realized tulip bulbs weren’t great long term investments back in the 1630s. We’ve had two difficult bear markets, first from 2000-2003 and again in 2007-2009. Both lopped off close to 50% from equity values and both had the same root cause: irrational human confidence, first in tech stocks and then house prices. Justice delayed is justice denied, and investors swiftly paid for their mistakes once the bubbles of their exuberance popped.
Perhaps it is a psychological echo from our country’s Puritan founders, but the notion that bear markets are “Punishment” for the error of our collectively greedy ways is a popular narrative. The wrongdoer - and let whoever is without sin cast the first stone – must go through his or her punishment before achieving redemption. Only after that penance is complete can we enjoy the next period of growth and expansion. The error of our ways may vary. Excessive enthusiasm for sock puppet mascots and their dot com business models one market cycle, sloppy residential real estate lending the next. But in the end, we pay for our wrongdoing and move on, hopefully wiser and more cautious.
If this narrative of crime, punishment, and rejuvenation holds, current equity market valuations should be – at worst – accurate representations of future cash flows and discount rates. They may even still be cheap. After all, we’ve paid dearly not once, but twice, for terrible errors in judgment over the last 15 years. Pencils should be sharper, minds clearer, and portfolios more thoughtfully diversified than at any point in the last two decades. That’s the basic Puritanical structure of sin, penance, and forgiveness. Wear your scarlet letter, contemplate your moral failings, and live a better life going forward.
The problem with this argument is that it ignores a cold reality of the human experience: punishment is a poor motivator for changes in behavior. Consider the following points from the world of criminal justice:
In 2011 the Pew Charitable Trusts published an extensive study on recidivism – when people already jailed once for a crime must return to prison, convicted of another serious offense. The central finding was that more than 43% of all past inmates end up back in jail for another crime within three years of their initial release, despite that the U.S. spends more than $50 billion annually on its prison system. That is more than the GDP of most of the countries on the planet.
This rate has been fairly constant for several years, at 45.4% for inmates released in 1999 and 43.3% for those released in 2004. Results vary widely by state. California has a 59.5% recidivism rate, using samples from 1999-2002 and 2004-2007, while Virginia’s is essentially half that at 28.7% over the same periods.
Technical violations of parole – missed meetings with an officer of the court or social worker, for example, represent 26% of the cases. New crimes are 20%. Again, results vary by state. Arkansas has a unique program for parolees that essentially eliminates the chance of breaking parole. Still, its recidivism rate is 44%. California’s high rate, as noted, comes primarily from parole violations, and only 14-18% of its repeat offenders are convicted of a new crime.
The evidence shows that declining recidivism on a state level only comes with new programs that explicitly target the problem. Oregon, with the lowest reported levels at 22.8% in 2004, aggressively manages parolees’ transition plans back into the “Real world” even before they leave prison. Once out, punishments for breaking parole are gradual rather than an immediate trip back to prison.
How about those “Scared Straight” programs, where juvenile offenders get a stern talking to from seasoned inmates? Ever since the original film chronicled such an approach to dealing with at-risk teens back in 1978, this has been a popular program in many American states as well as other countries. Analysis of numerous studies on the efficacy of these programs yields a not-so startling conclusion: “the intervention on average is more harmful to juveniles than doing nothing.” One review of a Scared Straight program in California’s notorious San Quentin prison concluded: “it was clear that the San Quentin Squires Program did not reduce delinquency overall.” Even then, the program is still running to this day.
The bottom line is that punishment alone is not enough to change behavior. Doing time in America is no joke. Sentences are more severe than most other democracies, and conditions are generally tough at best and horrific at worst. Despite all this, the chances that someone who goes through this experience and commits another crime is essentially 50-50. And that’s a pretty sticky number, as the history shows. To shift the balance states have to fundamentally change their approach, as the Oregon experience highlights.
As far as how these insights should inform our perspective on investor behavior, the conclusions are counterintuitive but hard to dismiss. No, two bear markets in 15 years is not enough ‘Punishment’ to deter future ill-considered speculation. In the vernacular of the U.S. penal system, investors are actually working on their “Third strike” – the much harsher set of penalties for repeat offenders. At the moment, we actually aren’t too concerned that equity markets are actually in a bubble phase. Earnings are decent, there is just enough economic growth to hold out some hope for acceleration, and valuations are fair. Not cheap, mind you, but not insane as long as corporate managers keep costs in line. So let’s keep our appointments with our parole officer and stay out of trouble. Another trip back to the big house doesn’t help anyone.