Special Edition: What could still go wrong?

What could still go wrong?

Every now and again, it would be healthy for an investor to think about all the things that could go wrong. In many cases, the focus is on potential returns, rather than potentially capital-destroying risks.

Nothing is a more costly mistake than buying a mediocre company at a premium price. At least top companies can be expected to rise over time as the value of the business increases, while overpaying for mediocre companies is a mistake that may never be corrected. This lesson is one of the most important in the pandemic-era bubble, where even mediocre or poor firms were able to pretend to be excellent businesses. There was demand for all products and services in an economy frenzied by the stimulus. Or in some cases, companies didn't even need to have a product to sell, and manic investors still bought the shares.

Looking back on the year of euphoria, 2021, many things could and did go wrong. What if companies’ turnover and profitability levels were not sustainable? What if inflation were to wake up from hibernation? What if interest rates were to rise? What if geopolitical risks materialized?

Looking at the market now, in the warm November of 2023, a lot of things have indeed gone wrong over the last couple of years. Instead of a perpetual rise, the Helsinki Stock Exchange's overall index has fallen by 30% in nominal terms from the peaks of fall 2021. What’s more, this figure is as high as 40% when inflation is taken into account. Small companies were in the biggest bubble and are on average down 60% in real terms. In many companies that were listed during the hype period, the performance has been anything but what was painted in the IPO prospectus, and the investor's capital has been almost completely wiped out.

In addition to the weaker-than-expected development of individual companies, many of the risks at the general level have materialized.

I've always thought that ultimately stagflation is the most toxic environment for equities because inflation forces up interest rates while a weak economy squeezes results. Europe is flirting with stagflation. Interest rates are up, prices have risen, and earnings are falling hard. This risk materialized, and the aftermath has been ugly for the average stock. 

Another scenario that is usually devastating for equities is an outright financial crisis. Financial crises bring down banks, and when banks can no longer lend, the whole economy suffers long after the crisis is over.

However, it's just been 14 years since the last great crisis, and it took well into the 2010s to recover from the scars it left. Bank regulation has been tightened and central banks know how to maintain confidence in the economy. Moreover, even a small blip in the financial sector, such as the current global commercial real estate loans or China worries, will turn on the spotlights. Thus, a surprise from the depths of the financial sector seems unlikely, unless the shadow banking sector makes a splash.

For the long-term investors who know their companies well, economic cycles come and go. Good companies will navigate through them and with luck, a panicky market will provide opportunities to buy quality business with high ROICs on sale. Yet investors stress about recessions often. But even that risk has now partly materialized in practice. China's economy has slowed down, Europe and Finland are at least flirting with recession. At least the results are in a slump, and stocks follow the results. 

Geopolitical risks include trade wars and both cold and hot wars. The US and China have been engaged in a trade war since Trump's presidency, and the line has not changed under Biden. I don't think the countries' interdependence has declined much, but relations are chilling. Especially in the field of advanced technology, new sanctions are placed on the regular.

Russia's barbaric invasion of Ukraine is a tragedy, and it reverberates around the world, fueling inflation among other things. Of course, an even bigger risk for the global economy would be the much-predicted Chinese adventure in Taiwan, so not all the risks now identified have yet materialized in this area. The Middle East with its huge oil reserves is also like the Balkan powder keg of a hundred years ago.

Among the major risks, a pandemic materialized in the shape of COVID-19. The only thing that we’re missing would be disruptions to production chains caused by accelerating climate change as extreme weather phenomena increase. But this risk should not come as a surprise as investors shed more and more light on the so-called ESG risks, or whatever you want to call them, of their holdings.

Thus, the stock market is now in a situation where things have gone really badly for equities. I was once sitting in a pub, and a professional at the next table said that things are never so bad in life that they can't be made worse by alcohol. The same rule applies to the stock market: it can never go so badly that the bear market, dubbed the "scam market" by the Inderes Forum, couldn't continue. However, in the current situation quite a few risks have already been realized. That is, if we leave out of this discussion the more existential risks, such as a nuclear war or a meteor strike, whether deliberately or accidentally initiated. 

Investors tend to extrapolate the developments of recent years into the future. More good things are forecast for the coming years during a upturn. Similarly, after a couple of years in a bear market, it’s easy to become cynical and continue to see inflation, high interest rates, economic recession, unemployment and especially falling share prices.

Perhaps it would now be appropriate to ask, what if interest rates were to fall sharply? What if the economic downturn were to remain mild or even turn into a bull market at some point? Are all listed companies as bad as share prices suggest? What if instead of war there were peace? What if the Finnish economy, which has been going horizontal since the financial crisis, got a new boost from industrial investment because of cheap green energy? These ideas may seem utopian now, but a few years ago, so did these risks that have realized.

Pessimism always sounds smarter than optimism. It’s also difficult to distinguish pessimism from critical thinking, which is why it can sound constructive. Investment author and blogger Morgan Housel has written aptly about how it’s easy to point the finger at short-term risks and miss the long-term upside.

One of the best signs of rising living standards is the decline in infant mortality. In 30 years, deaths among children under five have fallen from 12 million to 6 million a year. That's too much, but it's the right direction.

Over the past 60 years, the world economy has grown from less than $500 to more than $12 000 per capita.

Believe it or not, the Helsinki Stock Exchange has historically been one of the best stock exchanges in the world. To be precise, 8th best over the last 120 years with an annual real return of 5.5%. The previous year being bad means nothing in the long run.

I would argue that the current pricing of the stock market is at a level where there are opportunities for the investor. What if things don't go quite as badly in the next few years as they did in the last couple of years? Every dog has its day. 

Thanks for reading the post! I hope it gave you some constructive food for thought. Read analysis and make good stock picks!