How?
Hedge funds, many driven by computer algorithms, bet that there would be a recession and the impact would be devastating for cruise lines, airlines, hotels, and other industries that would suffer in a recession. What went wrong? There was no recession.
Why did so many hedge funds beg big on a recession? Following the pandemic, there were several events which, historically, have preceded a recession.
Inflation soared to almost double digits as the pandemic came to an end. Many businesses which supply goods had been forced to put their work on hold during the pandemic, and the supply chain was seriously hampered. Shortages cropped up in multiple goods and prices jumped. Initially, economists and business leaders believed the inflation was transitory and that, as businesses restarted and the supply chain reverted to its pre-COVID state, inflation would subside. That did not happen. In response, the Federal Reserve raised interest rates; when this has happened in the past, it pushed the economy into a recession.
The warning signs continued when the yield curve inverted. In the past, that was almost always advance warning that a recession was on the way, likely within a few months. Then Russia invaded Ukraine. Most of the globe found themselves with a stake in that conflict, falling on one side or the other within hours. A disastrous global event has often preceded market volatility – if not a recession.
With history as your only metric, there was a high probability of a recession as soon as 2022. And this was exactly what the hedge funds and their algorithms were relying on when they bet that a recession was imminent. They shorted cruise lines, airlines, hotels, and similar companies that depended on consumer expenditures, which they assumed would collapse in the inevitable recession.
Peter Lynch said in his book One Up on Wall Street that investing is an art, not a science. If investing was a science, the person with the largest computer would always win.
Computers can scan, absorb, and analyze billions of pieces of data. Algorithms can be written to use history and make forward projections based on probability. But computers cannot drive around business districts and see the help wanted signs posted everywhere. Computers don’t step into a restaurant and see service is not what it was before the pandemic because the restaurant is understaffed. Computers do not talk to business owners who relate that half the applicants for a job interview never show. Not only do they not show, but they make no attempt to communicate this to the interviewer. For those that do show, they are hopping from one job to another every three or four months and getting a raise each time.
As investment managers for our clients, we do notice these deviations from the historical narrative. We noticed as early as 2016 the economy looked primed for inflation. We noticed, coming out of the pandemic, that many consumers still had all or a portion of their stimulus checks. When we were sheltering-in-place, many consumers were saving money by not dining out or vacationing. They had paid down some of their debts and had both a disposable income and a pent-up desire to do all of those things that they were unable to during the pandemic.
The computer algorithms missed all of that. We didn’t. We wrote newsletters spoke on the radio saying that the normal signs of a recession did not exist. Unemployment was not increasing as it normally does during recessions. Instead, there were more jobs than there were workers to fill those jobs. Consumers were not cutting back on their spending on restaurants and clothes and cars; they were buying more. Wages were not declining as they often do during recessions. Wages were increasing.
Investing is an art, not a science. The algorithms lost $6.4 billion by shorting the very companies that consumers were flocking to after the pandemic.
Most Wall Street gurus, computer algorithms, and business CEOs still believe there is a recession on the horizon. August and September tend to be weak for market moves, and so far in August, the stock market has been sliding down. The question is whether that is due to the normal lackadaisical summer and fall humdrums or if it precedes our long anticipated recession.
Increased consumer spending growth has slowed from 2022, but it is not negative. Unemployment remains low and there are still more jobs than workers to fill them. Wages continue to increase. While credit card debt has reached new highs, the delinquency rates are running close to historic lows. The average household spends less than 10% of their income on debt. That includes not only credit card debt but home mortgages and installment credit like car loans. The ratio of debt to household income is down to levels not seen since the 1990s.
We are guardedly optimistic that consumers will continue to spend, and the next recession is still several years away.
