How bad is this recession going to be?

A couple of weeks ago, I used a study by Edward Leamer to show that a recession in the US in the next 12 months is highly likely. Similarly, in the UK and Europe, a recession is likely as well. The upcoming data for third quarter GDP growth is probably going to be still slightly positive, but weak and it could well be negative. Since the last two recessions (the Global Financial Crisis in 2008 and the pandemic in 2020) were extremely deep, many – especially younger – investors fear it is going to be another deep recession. Well, I don’t think so.

First, we must consider who will be hit by this recession. Yes, consumers will reduce spending given the enormous increase in energy and food prices. And the housing market will weaken because of higher mortgage rates. But be aware that compared to 2008, households today are in much better financial shape. Not only are there still some excess savings available for many middle and upper-middle class households from the pandemic days, but the debt they have to service is today quite a bit lower than in 2008. After the housing crisis, households spent many years reducing their debt loads and improving their financial position. And that will help us in the coming recession.

No, the problem in the coming recession will be corporate debt. Thanks to persistently low interest rates, many companies have increased their debt levels since the financial crisis. In the US, this trend was particularly strong and corporate debt excluding financial companies is now higher there than household debt. In the UK, corporate debt levels have not risen that much but are still quite high.

Debt levels in the UK and US

Source: IMF

Higher interest rates are going to hit corporations badly and will force them to reduce investments, pay back debt, and de-lever their balance sheets.

The good news is that this is what happens in any normal business cycle recession. Some businesses will be over-levered and will go under. Others will have to reduce their debt load and repair their balance sheets. But as Oscar Jorda and his colleagues have demonstrated for a set of 17 developed countries, such episodes of corporate debt overhang do not lead to the deep recessions that we have seen in the aftermath of a housing crisis. The chart below shows the average change in GDP per capita of a country when corporate debt levels decline after a period of fast-rising debt levels. In comparison, it also shows the same data for the aftermath of fast-rising household debt. As you can see, the aftermath of corporate debt booms is much more benign with GDP declining for one year and then recovering pretty quickly again.

So, unless something unexpected happens and we do get a major financial crisis again, I am not too worried about the coming recession. It is probably going to look very similar to the 1990/1991 recession and not like the 2009 or 2020 recessions at all.

GDP/capita in the aftermath of corporate and household debt booms

Source: Jorda et al. (2020)

Engagement works

ESG investing is long past the point where it simply excluded some companies. Today, engagement with management is the name of the game. But does engagement work?

Vicente Bermejo and his colleagues tried to figure out what influence investors have on the ESG practices of companies and compare this to the influence of the company itself and the CEO of the company. This is much harder than it sounds because you need to have a complete dataset of companies, their CEOs, and their entire investor base plus the shareholder votes at AGMs on ESG issues. Stating with the companies in the US covered by MSCI ESG, they collected this data for some 5,300 companies with some 7,700 CEOs and some 7,500 large institutional investors between 1992 and 2018.

Based on that data, they could examine how much of the variation in ESG practices between firms is due to investors and other important stakeholders. The relative importance is shown in the chart below and the good news is that some 40% to 50% of the variation in ESG practices is driven by investors engaging with the company. That is typically more than the influence of the CEO and the company itself. In other words: Engagement works.

Without investors pushing for change, companies would be much more lethargic in improving their ESG credentials. The only area of ESG where companies seem to be doing fine on their own is the governance area. In the environmental and social dimension companies need to be pushed by investors to do something.

Ironically, when pushed by investors through engagement or votes on ESG topics at shareholder meetings, companies do change their business practices and that has benefits for the company and its shareholders. The research by Vicente Bermejo shows that once companies improve their environmental and social business practices, risks in these areas drop. Corporate management may think it only increases admin work and costs but what these initiatives really do is save costs in the form of lower risks and fewer losses for shareholders.

Thus, to all investors, I say: Keep engaging. You are doing the right thing and you are making a difference.

Relative importance of stakeholders in changing ESG practices

Source: Bermejo et al. (2022)

Narcissists and conspiracy theories

By now I have written six posts about narcissists, which should give you an idea that I am somewhat interested in them. But let’s be honest, narcissists are fascinating and interesting. Just ask them. They will tell you.

As part of my reading about narcissists, I came across an interesting overview paper that summarizes the empirical evidence that shows that narcissists are more likely to believe in conspiracy theories. In essence, the paper argues that conspiracy theories appeal to narcissists in three ways.

Three pathways why narcissists like conspiracy theories

Source: Cichoka et al. (2022)

First, many narcissists display what is called “agentic extraversion” which is a fancy word for the need for admiration, and using grandiose stories and exaggerated claims to boost their egos and create that very admiration that they crave. Well, a key component of conspiracy theories is that they claim there is a group of people that has special insights into how the world works. Being part of this small group of enlightened people creates exactly that kind of ego boost narcissists want.

The second driver for narcissists is their antagonism. Almost all narcissists feel threatened by other people, particularly the ones they cannot control. Other people are intentionally malicious and in particular politicians, billionaires, and other powerful people that narcissists intuitively know are more successful than they are, are perceived as out to get them. Join this with an intense need for control and an intense fear of defeat. This is why before narcissists accept and admit defeat, they rather stick to conspiracy theories that allow them to retain control over the situation and tell themselves that they have been cheated out of what is rightfully theirs. In this respect, it is interesting to note that narcissistic people typically lack self-esteem. Individuals with positive self-evaluation and satisfaction about their achievements in life are less likely to be narcissists. In essence, narcissists think they are losers, which is why they cling to theories that others are out to get them, so narcissists don’t have to change anything about their lives.

Third, narcissists are much more gullible than the average person. The very fact that they are so in love with their abilities makes them shut down critical assessments of the people they interact with and the “information” they encounter. The technical term used here – and I am not making this up – is “bullshit receptivity” which can be observed in individuals but also in groups of individuals up to the point of entire nations. This study showed that citizens of countries that promote a feeling of exceptionalism are more likely to believe and spread conspiracy theories. This is maybe why countries like the United States and the UK have seen conspiracy theories spread more widely in recent years than countries like Germany or Switzerland. The narrative of American exceptionalism or – to a lesser extent – of British superiority is still very much alive in the US and the UK and forms a much bigger part of national identity than in other countries (no offense to my American and British readers).

These three pathways are all tapped into by conspiracy theories which is why so many narcissists tend to fall for them. The funny, or rather an unfunny result of these three traits of narcissists is also that narcissists are more likely to aim for a career in politics. Becoming a politician also feeds all three needs of narcissists. This paper summarised the impressions of more than 1800 experts on 157 democratically elected political leaders. The 14 leaders with autocratic tendencies in that study were associated with much stronger narcissistic tendencies than less autocratic leaders with the same political lean. In essence, we often don’t get the political leaders we need because the people who run for office are already skewed towards more narcissistic people. And the most grandiose and outrageous of these candidates often make it into office because they provide the best show and are most entertaining. The result is that we, again and again, elect people that turn out to have rather strong autocratic tendencies.

Analyst Top Picks work

Since 2002 equity analysts in the US have been forced to use a three-tier rating system for the stocks they cover. This Buy/Hold/Sell scheme has become ubiquitous worldwide now, but with it also came the trend towards analysts picking their high conviction ‘Top Picks’ in their coverage. This brings us to the question if analysts are able to pick the winners among their winners, i.e. do analyst Top Picks perform better than analyst buy recommendations on average?

The short answer for the TikTok generation is: Yes, analyst Top Picks outperform the average buy-rated stock.

Outperformance of analyst top picks vs average buy-rated stock

Source: Birru et al. (2020). Note: The alpha shown is annualised. In practice, most top picks remain Top Pick for several months, but less than a year.

For all the rest of us who have an attention span longer than a goldfish, there is some nuance to it though, that is important to keep in mind as Justin Birru and his colleagues describe.

First, analyst Top Picks on average tend to be more frequently house stocks, where the company is an investment banking client, than the average buy-rated stock. On average, a house stock is about twice as likely to be picked as a Top Pick than a buy-rated stock that isn’t a house stock. Interestingly, despite this bias, house stocks that are selected as Top Picks still on average perform better than the average buy-rated stock by the same analyst. The outperformance is only about half as much as for analyst Top Picks that are not house stocks, but it still is worthwhile for investors to pay attention to analyst Top Picks even if they are house stocks. This is encouraging since analysts tend to do a good job selecting the stocks that perform well despite the occasional conflict of interest.

Even more important for both analysts and investors is that analysts cannot fool the market with Top Picks that are investment banking clients or that perform poorly. On average, stocks picked by analysts as Top Picks see more media attention and trading as investors try to gain exposure to these high-conviction ideas. But Top Picks that are house stocks tend to see a smaller increase in trading volume than Top Picks that are not house stocks. Investors aren’t stupid. If an analyst picks a Top Pick that is also a house stock, investors take this recommendation with a grain of salt. If they are convinced of the underlying fundamental case, they still will trade in this stock, but they will not just accept an analyst recommendation at face value.

And over time, investors learn which analysts they can trust. By splitting analyst Top Picks into stocks that end up in the top quartile by performance afterward vs. stocks that end up in the bottom quartile, the authors of the study were able to track what happens if an analyst makes poor Top Pick recommendations. Every analyst will have a poor-performing recommendation from time to time. That is normal and part of the job. But over time, investors learn, which analyst recommendations they can trust and which ones they cannot. Analysts with poor-performing Top Picks will face declining influence in the market and increasing career risk. Declining influence insofar as trading volume in response to their selection of Top Picks declines if investors don’t trust the analyst. Increasing carer risk insofar as analysts with poor-performing Top Picks are more likely to lose their jobs or be demoted.

So, in general, analyst Top Picks are well worth paying attention to. They tend to work, and they give investors a simple and easy way to track the quality of an analyst. And for analysts, it pays to choose their true Top Picks because they face adverse consequences if they just try to curry favour with house stocks. All that will do is ruin their reputation in the market, which is why analysts are eager to pick their best stocks to the best of their abilities.

Has 2022 made investors shy away from stocks?

Yesterday, I ended my thoughts on the question if households have increased their equity investments as a hedge against inflation. Some households may even have made their first equity investments in the search of higher returns that can compensate for inflation. But if some investors have come into the market recently, their experience with stock markets would have been anything but good. Does that mean they will sell equities and shy away from the asset class in the future?

This is where a series of lab experiments performed by researchers from UC Santa Barbara can help us understand how investors react to their first steps in equity markets. The experiments were deceptively simple. The researchers asked a bunch of students to decide which one of six ‘lotteries’ they wanted to play. The first lottery was a safe investment that paid out 28 points, each point worth $0.15 for a total profit of $4.20. The next five lotteries were increasingly risky but also came with increasing expected payouts ranging from $4.50 to $10.80.

The participants were asked which one of the lotteries they wanted to play. Then they would roll two dice and if they rolled an even number, they would earn the higher of two outcomes, if they rolled an uneven number, they would earn the lower of two outcomes (i.e. a 50/50 chance for higher or lower returns).

After the participants made their original choice, they got to practice the game for 24 rounds and then were asked to make the same choice of lottery again. The chart below shows how many participants chose each lottery at the beginning and after 24 rounds of practice with the game.

Risk aversion before and after practice with a lottery game

Source: Charness et al. (2022)

Interestingly, as participants became more familiar with the risk-return trade-off, they became more willing to accept additional risks if it was compensated with higher returns. In essence, most people became more comfortable with financial risk as their experience grew. The effect was stronger for women than men indicating that women build more confidence in their investment decisions as they gain more experience.

But here is the interesting thing. The lottery game never created any losses. All options in the game provided positive returns, just some returns were higher than others. To assess whether participants who incurred losses would stay away from risky lotteries one has to look a little bit deeper. And whether the participants had a lucky hand in selecting lotteries or not didn’t make much of a difference. Even the participants who experienced more negative outcomes in their practice rounds were on average switching to a riskier lottery after practicing.

This result flies somewhat in the face of loss aversion or risk aversion theory and certainly is the opposite of the snake bite effect documented in behavioural finance. The researchers examine why there may be no snake bite effect in their experiment and the answer seems to be that investors in their experiments were quite hands on and involved with their investments. This immersion in their investments created a stronger learning curve that eliminated the snake bite effect. In other words, the more front and centre the outcomes of your investment decisions are, the faster you learn. And that makes me confident that the poor returns of 2022 so far have not created a group of new equity investors that shy away from the asset class forever because of their short-term losses.