The Stock Market vs. The Economy, and Assessing Risk Tolerance (EP.94)

Episode Summary

Executive Summary: In this episode, the hosts share personal updates amid the pandemic and delve into economic analysis from a webinar featuring economist Edward Lazier, who discusses the supply-based recession, the importance of testing, and V-shaped recovery potential. They contrast the stock market's forward-looking nature with backward-looking economic data, explore research showing a negative correlation between GDP growth and stock returns, and examine risk tolerance measurement using utility-based questionnaires to prevent panic selling.

Main Topics: Economic Analysis from Edward Lazier Webinar (Priority: 5/5): Lazier, a Stanford economist, analyzes the pandemic's economic impact, predicting a 25% output decline, emphasizing the need for testing to determine death rates, comparing to WWII supply shocks, and warning against premature monetary tightening to avoid a 1937-style relapse. Stock Market vs. Economy: Forward-Looking vs. Backward-Looking (Priority: 5/5): The hosts explain that stock prices reflect future expectations, not current economic data. They use historical examples (e.g., 2008 crisis) to show markets often rebound while economic indicators still deteriorate. GDP Growth and Stock Returns: Negative Correlation Research (Priority: 4/5): Papers by Ritter and Arnott/Bernstein show GDP growth is negatively correlated with stock returns due to expectations being priced in and dilution from new equity issuance, using China as a prime example. Risk Tolerance Measurement and Utility-Based Questionnaires (Priority: 4/5): Exploring Riskalize's approach using lottery-type gambles tied to investor’s actual portfolio size to find the 'get-me-out' point, arguing psychometric questionnaires are less effective at preventing panic selling. Index Rebalancing Delays and Market Impact (Priority: 3/5): Discussion of S&P delaying quarterly rebalancing due to volatility, affecting State Street ETFs, and hedge funds losing money on failed rebalancing trades, highlighting the unpredictability of such events. Bad Advice of the Week: Market Timing and Thematic ETFs (Priority: 2/5): Critique of advisors trimming equity exposure during rallies and Direction ETFs launching a 'Work from Home' ETF (WFH) to capitalize on trends, emphasizing the folly of timing and hot product chasing. Personal Updates and Life During Lockdown (Priority: 1/5): Hosts share personal news: a new baby, drone pilot license, CERB application success, and recommendations for books, Netflix documentaries, and cooking.

Key Arguments: The current recession is supply-based, not demand-based, making a V-shaped recovery more likely if businesses survive the shutdown. Stock market movements are driven by expectations relative to unknown market consensus, not absolute economic data; thus, bad news does not necessarily mean lower prices. Higher GDP growth does not translate to higher stock returns over the long term; in fact, the correlation is negative due to overpricing of expected growth and dilution from new equity issuance. Effective risk assessment should use consequential, specific, and simple gambles tied to the investor's own portfolio to identify the true point at which they would bail out, rather than generic psychometric questions. Central banks are likely to be cautious about tightening policy due to historical fear of repeating the 1937 recession, supporting a prolonged accommodative stance.

Data Points: Predicted economic output decline: ~25% for the quarter - Based on employment numbers, stated by Edward Lazier. Percent of U.S. economy affected: 20-25% - Lazier's estimate of how much of the economy is directly shut down. Iceland's infection rate multiplier: 4 to 4.5 times - More people infected than identified, implying a lower death rate. Average recession length since 1945: 11 months - Based on NBER definitions from the Dimensional webinar. Average equity premium – all months: 65 basis points monthly - From 1945 to present, based on Dimensional's data. Average equity premium at recession peak: -2.2% - Negative 2.2% average equity premium at peak and following two months. Average equity premium at recession trough: +3.2% - Positive 3.2% average equity premium at trough and following two months. Correlation between GDP growth and stock returns (developed markets): -0.39 - From Ritter's 2012 paper, 1900-2011, 19 countries. Correlation between GDP growth and stock returns (emerging markets): -0.41 - From Ritter's 2012 paper, 1988-2011, 15 emerging markets. Additional road deaths after 9/11: 1,500 - Unintended consequence of people driving instead of flying, cited from Daniel Gardner's 'The Science of Fear'. Canada job losses in March 2020: Over 1 million - Record job losses, yet TSX rose 1.75% on release day. U.S. unemployment rate potential: 32% - Fed estimate from the Bloomberg headline discussed.

Pivotal Quotes: "The stock market is a forward-looking pricing machine. The stock market's pricing and features expectations about cash flows and risk." — Benjamin Felix: Explaining why economic data and market moves can seem disjointed. "We find no evidence that yield curve inversions can help investors avoid poor stock returns." — Fama and French (quoted by Benjamin Felix): From their 2018 paper 'Inverted Yield Curves and Expected Stock Returns'. "It does not make sense to change your asset allocation because you think that you'd have new information about expected returns. You don't, unless you can predict where the peak and the trough are, expected returns are basically the same in every other month." — Gerard O'Reilly (quoted by Benjamin Felix): From the Dimensional webinar, on equity premiums during recessions. "What makes a good questionnaire? One that leads investors to stay invested." — Charnas, Nisi, and Imus (quoted by Cameron Passmore): Conclusion from the paper on eliciting risk preferences.

Implications: Listeners should understand that stock markets are forward-looking and not tied to current economic news, avoid market timing based on GDP data, and ensure their risk tolerance assessment is based on their own portfolio size and genuine 'get-me-out' point to prevent panic selling, which can permanently impair returns.