Image by Patrick Tomasso
 

ARE WE THERE YET?

June 23, 2022

Article via Gavekal Research


As young parents, my wife and I would bundle our four children into the car for a nine hour drive to my parents’ house in southern France. Mere minutes after starting on the road, at least one child would ask a question that the others would often repeat throughout the journey: “Are we there yet?”


Many years later, I find a similar question being asked of me regarding the current bear market. Though the context is very different, the implied questions are the same: “Is the pain over yet? Can I start having fun again?”

My answer depends on the nature of the bear we are facing. If we are in a gentle, black bear market—meaning -20% from top to bottom—then yes, the worst of it is over. If, however, we are in an Ursus magnus of -50% or more, then there is more pain to come. Unfortunately, there is a high probability that we are in such territory.

It would not be my first experience with such a market. My career started at the top of a bull run in 1971 before plunging into a four-year Ursus magnus, with the S&P 500-to-gold ratio tumbling from 100 to 14.

  • February 1971, I am hired by Banque de Suez, a merchant bank in Paris; a glorious future is in front of me. The S&P 500-to-gold ratio peaks at 102.

  • August 1971, Richard Nixon cuts the link between gold and the US dollar. The first leg of the bear market moves the ratio to 60 in 1972, but a rally at the end of 1972 brings it to 70. Nixon is triumphantly reelected.

  • In the first six months of 1973, the market loses another 50%, and the ratio hits 32.

  • September 1973. As no one at the bank could explain what was going on, I leave to create a research firm based on asset allocation—a relatively unknown concept at the time. A month later, the Yom Kippur war sends the price of oil through the roof. The S&P 500-to-gold ratio hits 20.

  • September 1974. Louis is being christened as the ratio passes 17. After the ritual, the priest asks me what I do for a living. “I am loaded with French equities,” he confessed after learning that I worked in finance. “What should I do?” My answer was simple: “Pray, Father. Pray.”

  • By end-1974, the ratio bottomed at 14, and I was a nervous wreck. 

Thus ended the Ursus magnus, a traumatic experience that shaped the investment philosophy of those who lived through it. Alas, there are fewer and fewer of us, so I would like to share three lessons I have learned.

  • According to Warren Buffet, a bear market is the process through which capital returns to its legitimate owner. If such a process has just started, given the excesses of the last decade or so, it may take both time and heavy price movements for the assets to return to their legitimate owners.

  • Initially, nobody understands why the market is falling and the return on invested capital is collapsing. In 1973-1974, soaring energy prices helped crater ROIC around the world. The S&P 500-to-gold ratio had fallen by-70% and would tumble another -50% from there. As Irving Fisher wrote in 1934, over-indebtedness is always the cause of great bear markets. My educated guess is that the next Ursus magnus will arise from a collapse in both European bonds and social democracies, leading to a drop in consumption of the middle class similar to the Asian Financial Crisis.

  • By the end of the bear market, no one will be asking “are we there yet?,” as those who did would have already been fired. Investors who ask such a question tend to be those who achieved success by borrowing to buy more as the markets went up. In a bear market, however, the survivors are those legitimate owners of capital. One such investor was my mentor, a Swiss banker named Ernest Gutzwiller who told me his secret to success: “Never lend money to somebody who needs it.”

Stanley Kafka of Freedom Finacial Funds comments on the article from Gavekal Research:


"I am always skeptical of using historical relationships such as linking a commodity (Gold) to the stock market index (S&P 500) to forecast anything although it makes for interesting reading as a theory. On one hand, there is the old saying about "He who ignores the lessons of history.....", but on the other hand, the causes were different for every RE recession ('66, '70, '74, '81, '90, and 2008) and were missed by the great sages who were looking in the rear0view history mirror at the cause of the previous recessions and go blindsided. So, the article would make interesting reading 6 months from now, and what was he saying 6 months ago?"