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Jan 2, 2024

Are We In For A Minsky Moment?

by John DeGoey

Although there have been setbacks over the past while, there can be little doubt that the past 14 years have been kind to investors. Both the economy and the capital markets hit a low point in Q1 2009. Since then, things have been mostly positive, with a few relatively minor hiccups along the way. In the aftermath of the global financial crisis, employment rose, stocks went up, and until recently, inflation was kept in check. 

Many people understand, but fewer people are willing to acknowledge that we are likely experiencing a severe credit bubble. By the middle of 2023, asset prices in general, and real estate prices in particular, have reached nosebleed levels. I am now hearing stories of large numbers of distraught landlords who thought they were fine with their pre-existing mortgages who are now needing to come to terms with those mortgages being unsustainable at current rates. Their rental income is no longer high enough to cover monthly debt obligations. For most people, this amounts to nothing more than a minor inconvenience, and they will simply add $200 or $300 a month from their current income to cover the shortfall. For those who cannot produce the money needed, however, foreclosures loom. If this outcome is relatively isolated, there's not much to worry about. The problem is that the trend seems to be accelerating.

Hyman Minsky was an American economist who was a disciple of Joseph Schumpeter. He built on Schumpeter's concept of “creative destruction” by suggesting things can go south quickly once they reach a tipping point. That point has come to be known in popular lexicon as a "Minsky Moment". A Minsky Moment occurs when there is a sudden but severe collapse in asset values. This is typically marked by the end of a growth phase in a business cycle, the peak of a credit market cycle and or a peak in business activity. It usually comes after a prolonged period of relative prosperity, which is why people can be blindsided by it.

A major part of the problem in dealing with the concept of a Minsky Moment is that few people see it coming. The optimism bias of the financial services industry—something I call Bullshift—is a pervasive element of how people think and act today. More precisely, optimism bias is when people think bad things cannot or will not happen to them. As soon as you start to think you're impervious to negative outcomes, you tend to let your guard down—and if those negative outcomes manifest, they can be more harmful than they otherwise might be.

As of early 2024, we are now awaiting the onset of what many are calling “the most widely anticipated recession in history”. Given that it is so widely anticipated, investors might be forgiven for questioning the degree of preparedness people have baked into their decision-making. The distinction, it seems, is one of degree. Even if you expect that there will be a recession, you may be ill-prepared if you buy into the industry's dominant narrative that it will be short and shallow. 

If Minsky's hypothesis plays out, many people are likely to be unpleasantly surprised by the breadth, depth and overall severity of what may well ensue. Anticipating that a negative outcome will be only modestly negative can still leave you blindsided when the outcome occurs if it is far worse than you expected.

We've had three major market downturns in the past half-century in North America. In 1974, markets dropped because of the stagflation brought about by the OPEC (Organization of the Petroleum Exporting Countries) oil embargo. 

Secondly, in the period from 2007 to 2009, the world experienced a severe credit crisis which resulted in, among other things, massive defaults and foreclosures as a result of real estate hitting bubble territory. All three of these drops were between 40% and 60%. 

Finally, inflation has been a problem for a couple of years now, and even though it is lower than it once was, it is still far too high, and now it looks as though economic growth is beginning to stall as well. Shortly after the turn of the millennium, valuations for stocks in general and growth stocks, in particular, reached stratospheric levels. Beginning in early 2022, those levels have once again been tested. 

As we head into 2024, all three of the scenarios that caused capital markets to drop significantly in the past half-century are with us again, only this time, they are with us simultaneously. We're living in a world where persistent stagflation remains a real possibility, where valuations are excessively high, and where credit has become stretched. If any one of these problems causes the situation to spiral out of control, the others may be realized via first-derivative consequences.

All the macro-level policy choices which have led to a high degree of optimism have left many feeling they are bulletproof and unlikely to experience a severe setback. Again: the three biggest setbacks in our adult lifetimes have been caused by stagflation, high valuations, and a credit bubble, respectively, and all three of those circumstances exist today. That confluence is unprecedented.

None of this is being written with the intent of being a gratuitous scaremonger. The last thing I want is to be a financial Chicken Little. Rather, the intent is to cause readers to stop and reflect upon what their portfolios currently consist of and whether the elements of that portfolio are truly reflective of their risk profile. Risk profile, in turn, involves two primary elements: tolerance and capacity. 

Financial regulators have come to assess portfolios as being suitable only when they approach the limits of the lower of those two metrics. For instance, if your risk tolerance would allow you to have an 80% equity exposure but owing to other factors—perhaps financial insecurity or poor health or a forthcoming retirement—your risk capacity would only allow for 60% equity exposure in your portfolio. As such, you should not have more than 60% in equities even though you could technically tolerate more.

It seems that 2022 provided an interesting case study of human behaviour. In the first ten months of that year, a typical 60/40 portfolio lost over 15%. Despite the discomfort that many investors experienced, the vast majority had the focus and discipline to stay the course and, as a result, experienced a healthy uptick from November of 2022 to now.

Recency bias is when you make decisions based on whatever happened in the recent past on the assumption that a similar outcome is likely to happen next time. While that is certainly true some of the time, it would be helpful to recognize that some investors may be “fighting the last war” in making decisions based on what happened last time rather than trying to meaningfully anticipate what might happen next time.

Whether or not you share my concerns, it probably wouldn't hurt to do what behavioural economists call a “pre-mortem”.  As a purposeful thought exercise, carefully consider what could go wrong before things actually go wrong to satisfy yourself that you're doing what is needed in advance. Should the bad news materialize, you will have proactively prepared. There's a real chance that many investors are guilty of optimism bias and overconfidence, but I don't want to admonish anyone. I simply ask that you consider what I believe is a very real risk. I think the odds of experiencing a Minsky Moment in 2024 are high. Of course, I may be wrong—and I absolutely don't want to be an alarmist. However, I also don't want this opportunity to pass without drawing my concerns to your attention. Do what you think is best for your circumstances. Good luck.

John De Goey is a Portfolio Manager with Designed Securities Ltd. (DSL). DSL does not guarantee the accuracy or completeness of the information contained herein, nor does DSL assume any liability for any loss that may result from the reliance by any person upon any such information or opinions.