Market Climatology
Market Cycles as Climatology
My view of the market environment works a lot like Google Earth. You start with the very high view and zoom in. But since we work in an environment where the flow of time is an important component I find it useful to think of the capital markets in a way similar to the “atmospheric sciences” approach. Climatology studies weather conditions over periods of at least 30 years. But much climatology is classified in terms of “ages” that last hundreds or even thousands of years. Meteorology, on the other hand, looks at weather patterns over hours, days, and weeks. Climatology is more concerned with the long term trends behind near-term, meteorological patterns. But meteorology, that daily weather report, impacts our regular lives because we are short-lived creatures who barely notice the underlying trends as the climate changes. We have a hard time distinguishing between today’s rain storm and a gradual increase in global sea levels.
The capital markets and economies work in much the same type of environment. We think we have terms for them as well: macro and micro. Macro economics deals with the trends in the broader economy while micro economics deals with business activity at the corporate level. In the markets we have macro market models which deal with overall market direction as they affect market indices. At the micro level we have security selection which picks individual securities like stocks which operate under the macro market environment. Unfortunately, even at this level, macro and micro markets and economics are still dealing with meteorology. What we call “macro” is like looking at the weather forecast for the Northeastern US while “micro” is the forecast for Boston. Neither is really looking at the long term factors influencing markets and economic activity. This is reasonable, because we are still short-lived creatures whether we’re looking at the weather or the markets. So it’s not surprising that we’re more concerned with what looks like the here and now.
The True Long Term
So if our “macro” view isn’t really long term, what is? Again, climatology vs. meteorology gives us a clue. One well known climate element which influences the weather is the El Nino effect.
El Nino/La Nina, or Southern Oscillation, is an irregular change in the temperature in the tropical southern Pacific Ocean which can affect weather patterns across the globe. The Southern Oscillation can affect, for instance, whether hurricane activity in the Atlantic is above or below average. Hurricane seasons still arrive as always, but their intensity will change. In a similar way the Southern Oscillation can affect whether we have drought in the Southwestern US or more severe winters in Northeast. Note that the seasons keep coming and going, but their character changes depending upon whether the Southern Oscillation is operating. There are even longer influences on the near term weather like the CO2 in the atmosphere which are much more difficult for us short-term creatures to notice. So the Southern Oscillation is itself influenced by global warming and cooling trends that last for even longer periods.
The Southern Oscillator over time. Note the long time periods to complete a cycle. (By Rainald62 - Own work, CC BY-SA 3.0)
Regional Impact of La Nina. Source: NOAA
So a long-term economic or market element is something which would influence the character of the typical market and/or business cycle.
Research has identified two of these longer term conditions: Inflation and financial leverage.
The markets and economies operate differently when inflation is at higher or lower levels. Research supporting this has been around for a while, but investors always seem surprised when the inflation regime changes. The reason? The inflation regime can last for 20 years, a generation of time for us finite creatures. To give you an example, being an old-timer, I remember the high inflation of the late 1970s which was early in my career. Starting around 2019 I became concerned that high inflation was going to come back. To discuss the impact of high inflation on markets, I referred back to my experience in the 1970s and showed how market behavior changes under high inflation in a series of papers. I was told by several people that I was “living in the past” because I was often talking about the 1970s. It was even suggested that I wasn’t prepared for today’s markets. I was vindicated in 2022, but I bring up this anecdote to show how people are unprepared for one of these long term regime shifts despite many research papers illustrating their impact. Aside from those academic studies, I wrote several papers in 2020 which are in the Publications section.
Financial leverage deals with the Financial Instability Hypothesis of Hyman Minsky. But the level of borrowing in the financial system, particularly by individuals and institutions rather than the government, determine the depth and length of recessions and bear markets. Since the financial instability regime can last from 8 to 20 years we do have recessions and bear markets without a financial crisis. They tend to be short and shallow. But a recession and bear market tied to financial instability can be long and deep like the Global Financial Crisis of 2008 which also surprised investors though we saw a similar chain of events during the Russian Financial Crisis of 1998.
Just as the Southern Oscillator affects the temperature and weather patterns across the globe, inflation and financial leverage can affect the character of the market and business cycle. For this reason a Market Climatology must take into account the levels of inflation and financial leverage which are the backdrop for the typical outlook for the market and business cycle.
The climate is a complex dynamical system, as is the global economy which includes the capital markets. So the relationship between the climate and the markets is not that big a leap in the end.
What Comes Next?
In the following posts I introduce the elements necessary to understand Market Climatology. But these introductions are short essays to acquaint you with the concepts. The Publications section will have more information. But the newsletter and accompanying research will go into even more detail.
By the way, I use the term “climatology” rather than “market climate” because that latter term is widely used for the meteorology of the market rather than the real climate.
