There are only 2 kinds of negative calls on financial assets that make sense to me.
#1. Get out, and never come back. One example: a company that is a serial destroyer of shareholder capital (earning a lower return on capital than the cost of that capital), which also carries an unhealthy amount of financial leverage. These stories can levitate for a time but the ending is never pleasant. Best case, such companies are purchased by better operators in their industry or shrink down to a manageable size on their own. Worst case, they disappear.
In the macro world, the most common exemplar is a poorly structured asset class that has been artificially inflated with liquidity to the point where future returns will be profoundly negative. Think low quality mortgage paper in the mid 2000s, and you get the idea.
#2. Watch out below. While nowhere near as toxic as the prior example, this bear case can still leave a scar on portfolios. The old joke about “what’s the difference between a good company and a good stock?” tells the story here. The answer: “Valuation”. Industrial names like CAT (down 14% YTD) and DE (down 6% YTD) are good examples. Both are fine companies, but first and second order trade/tariff worries have dinged investor confidence. Which is another word for “Valuation”.
The top of mind macro example: US equities right now. No one doubts the domestic economy is doing well. Fed policy, as we saw in yesterday’s minutes, acknowledges that and markets expect higher rates as a result. How much higher is the question, which in turn drives valuation. Even the highest quality financial asset on the planet (and US equities clearly own that title) can have a wrong price. “How wrong?” is the only question that matters right now.
The problem we see at the moment: when volatility strikes - as it has this month - it is all too easy to conflate these two very different sorts of negative calls. Jessica has a great analysis of why we believe volatility will be with us through November in the next section. “Watch out below”, indeed.
Three quick examples to highlight how structural arguments (i.e. the first sort of bearish call) are creeping into the market narrative:
#1. Fed independence. I’ve read numerous mildly hand-wringing critiques of President Trump’s posture towards the Federal Reserve. They make little sense to me. Chair Powell is a former investment banker and private equity investor. That makes him 1) rich and 2) very thick-skinned. There is precisely zero chance he cares about the president’s viewpoint and equally zero probability Mr. Trump would fire him.
#2. US equity market structure. The way US equities trade has changed substantially in the last 20 years, becoming much more computer-driven. Also, index-tracking ETFs have replaced active managers. These are centerpieces of many negative calls on US stocks. What happens when the market drops and liquidity dries up? Or all those ETF investors decide to sell on the same day?
But do not forget that the largest crack in US equities during the modern era occurred back in 1987. There will always be volatility in equity markets, regardless of market structure.
#3. US Treasury debt levels. It was perfectly apparent after last year’s tax bill passed that America would need a much larger credit line. Deficits will run +$1 trillion for years to come. But as long as the dollar remains the world’s reserve currency (and the euro and yuan don’t seem to be putting up much of a contest here), the US should have a long enough runway to address the issue.
Summing up: regular readers know we think narratives drive asset prices over the short and medium term. The resurgence in US equity volatility has increased the gravitational pull of many “structural” bear arguments. The ones we highlighted above are examples of less-potent ones. Others we have written about in the last week, such as Chinese real estate, do worry us even if their connection to the US economy is weak.
The bottom line: US equities are in for a very rough slog, even though “the fundamentals” remain good. We remain confident in our bullish call, but worry that market psychology is still pointing in the wrong direction.