“Back to school” is a time that conjures up many emotions. Younger children see it as a time of change and excitement mixed with trepidation of new challenges ahead. For those a little older, back to school means trading the freedom of summer for the shackles of homework and, though they often won’t admit it, the feelings of change and excitement as well. As parents, we can remember our children’s feelings from our own experiences, but to us back to school is more of a reminder that things change and time passes in ways that are simply out of our control. Away from all of those sentimental feelings, there is something else about “Back to School” that people forget. It was the name of an amazing ‘80s movie, starring the one and only Rodney Dangerfield. IMDB summarizes the plot as follows: “To help his discouraged son get through college, a fun loving and obnoxious rich businessman decides to enter the school as a student himself.” Basically, Thornton Melon (Rodney Dangerfield) uses his money to buy his way into his son’s school to help his struggling freshman son. Along the way, he does all the things I’d do if I could do college over with unlimited money – he turns about a dozen dorm rooms into a giant suite, throws parties at bars and has Kurt Vonnegut author his term paper on Kurt Vonnegut. While he has an amazing time throwing his money around, it turns out his son really wanted to find success the hard way, not having everything handed to him by his rich and personable father.
The market volatility of August made me think about both aspects of “back to school.” From a purely cyclical standpoint, the market was overdue for a correction. No investor should expect the returns of risky assets like equities to go up in a straight line. It really should not matter to anyone whether or not the S&P 500 is up or down 4% on the year – in the grand scheme of things, it is very hard to predict markets in that tight of a band. In other words, a correction was as inevitable as the passing of time. Why, then, was there such an uproar over the past few weeks as the market swung from green to red? To understand that, we’ll need to look at what’s made this cycle unique, with a little help from Thornton.
This market cycle has been driven by the sustained effort of global central banks to artificially influence the flow of capital. The first step was lowering interest rates toward zero – something that all the major central banks have done. This is supposed to force money off the sidelines (who wants to earn zero?) and into risky assets. When this wasn’t enough, the central banks began quantitative easing (QE), buying assets themselves to force investors further out the risk spectrum. I’ll leave aside the debate over what QE actually accomplished, but there is little argument that it played a major role in the global equity rally over that same seven year time period. Along the way, global growth was supposed to get so strong that the central banks could remove the excess liquidity from the markets without causing issues. Unfortunately, this never happened. Growth has been slow and steady, but much lower than anyone expected coming out of a major downturn. Once it became clear that Chinese growth was weak, the markets reacted in a seemingly outsized way. The markets are now used to rich central banks diving in to save the day – the reaction is due to the fear that more money will not solve the problem this time.
Thornton has the best intentions when he goes to school to help his son. His mistake stems from the belief that having unlimited money gives him the power to buy his way out of his problems. Does this sound familiar? It is the route the central banks have chosen. Eventually, though, the school catches on and forces him to take a test to prove that he has learned the material himself. QE may have delayed a deeper correction, but inevitably there will be a test on whether or not markets can stand on their own. As an investor, this is likely to be an unpleasant experience. The central bank influence has artificially lowered interest rates and increased equity prices. A true test of QE will involve lower equity prices AND lower bond prices. Either global growth is about to shoot higher, justifying the price of risky assets, or there is going to be a long overdue movement back to fair value. Now is the time to allocate your assets accordingly. We’ve been careful to stay up in quality in a sector (consumer credit) that already had its correction in 2008 and with low correlation to liquid markets. The coming correction will create plenty of opportunities for those who allocate capital away from traditional stocks and bonds into cash and other uncorrelated assets.
Of course, there is another way this could end. Towards the end of “Back to School,” a diver on the university team gets injured. Of course, Mr. Melon is an accomplished diver. To win the tournament, he does a dive called the “Triple Lindy,” which involves an out-of-shape, middle-aged man diving off of three diving boards in succession and landing in perfect position. If the central banks could just figure out a way to do this, maybe we can have the perfect ‘80s movie style ending after all.
Anyone think Janet Yellen can land it? Now is the time to decide.