- Glenn D. Surowiec
Client Update, February 17, 2024: An obsession with recession?
“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
Sir John Templeton | Investor, banker, and fund manager
In our view, one of the most interesting economic stories of 2023 (and possibly of 2024) is the recession that didn’t happen or, more specifically, the apparent obsession with a recession that didn’t happen.
There are many reasons why so many economists forecasted a major economic event that never came to pass. Some of these are reasonable (“When you don't have an analogous period to look back to, it makes things incredibly difficult,” says Deutsche Bank chief US economist Matthew Luzzetti) and some of them are not (baseless doomsaying).
Will there now be a recession in 2024? We prefer not to speculate, and most economists have shown that they can do little more than make an educated guess. So, where does this inherent unknowability of a novel economic environment still in the process of recovering from the disruption of the pandemic leave today’s investors?
Our recommendation: stop thinking about the future in terms of predicting discrete events like recessions.
It’s not that the future doesn’t matter. It does! All our investment decisions ultimately reflect judgments about the future. We want assets that will grow over time, and that means we must assess the company’s value today as well as the value tied to its future. Think of it this way: as investors, we're trying to avoid buying the future above what the future is worth. In other words, we don’t want to pay $2 today for something that will be worth $1 tomorrow, but we will jump at the chance to buy something for $1 today that will be worth $10 tomorrow.
Consider this example of the importance of future value: a new startup is just getting off the floor. Perhaps it has already started making sales, but it doesn’t have positive earnings or cash flow yet. Any money is getting reinvested, without having reached the point of positive operating margin. None of that means the startup is worth nothing, however; it just means 100% of its value is tied to the future.
That is an extreme example, but it’s true to some degree of all companies. Stock prices today already capture what investors believe future value is going to be. Stocks tend to bottom out before rates do, for instance, because investors are already pricing expectations about future rate changes into their buying and selling decisions today.
This dynamic has a critical implication for investors; it’s the reason why timing the investing appropriately is just as important as accurately identifying a desirable position in the first place.
You can’t buy an asset during a period of high confidence and expect the same returns as buying it in a period of low confidence. When we invested in financial institutions in March 2009, a period of extreme low confidence, we deservedly earned higher returns than if we had waited five or six years. Financier Sir John Templeton refers to this dynamic as “maximum pessimism.” If your judgment about the quality of a business is correct, you should earn the maximum possible rate of return if you invest at the company’s lowest point, the point at which the fewest other investors have confidence in the company (“maximum pessimism”). By contrast, if you invest only when the consensus is rosy, then you only deserve average returns.
We can see an illustration of this point in the chart of Bank of America’s (NYSE: BAC) performance since the Great Recession. Pay attention to Line 1 (blue) and Line 2 (red).
Source: Google Finance, February 12, 2024
If you invested at the beginning of the Great Recession (Line 1), a point of maximum pessimism, your returns naturally go much higher (the vertical rise of Line 1) than if you invested after confidence returned years later (Line 2). As the Line 1 investor took a bigger risk than the Line 2 investor, they can, should, and do earn a bigger reward.
This dynamic is why it’s NOT so important, from an investor’s perspective, to accurately predict economic events like recessions. Instead, what’s much more important is identifying two key factors:
First, your baseline judgment about the business must be correct.
Second, you must beat other investors to that correct judgment about the future value of the business.
This is why venture capitalism and angel investing in entities like startups, all of whose value is tied to the future, is such big business. If the investor can get in on the ground floor of a genuinely great business at a time of pessimism or, at least, skepticism, they will reap greater rewards as a result.
This is also why economic downturns like recessions aren’t necessarily as scary as many investors treat them. We don’t say this to minimize the very real—and very painful—crisis that these events represent for many people. However, they do tend to be times of maximum pessimism when even high-performing companies experience a period of low confidence. In turn, that means opportunity. If you had the courage (and the means) to do what very few did during the Great Recession, you'd get outsized rewards.
In fact, we can even measure the difference in the size of the rewards. The annualized returns from the low point of a recession almost always outperform the returns from the high point of a recession—sometimes significantly. Those who put money into the stock market at the worst of the Great Recession, for instance, earned more than twice the annualized returns as those who put money in at the high point.
Source: Fool.com
Of course, this is precisely what we at GDS Investments do for our clients every day: carefully and painstakingly work to identify both the positions most likely to generate high returns and the point of low confidence to acquire to asset so that we can, ideally, maximize returns.
If you would like more insight into the GDS Investments thought process around evaluating assets, we invite you to listen to our recent conversation with John Mihaljevic, a Managing Editor of The Manual of the Ideas here or anywhere podcasts are found.
As always, I remain grateful to you for your ongoing support.
With warm regards,
Glenn
