Fear of recession is causing current turmoil in stock prices. Recessions are often precipitated by an abrupt return to reality, a moment when the market corrects itself after a prolonged period of distorted perceptions and misaligned incentives. Historically, we have witnessed how such misalignments can lead to the mispricing of assets, which can ultimately culminate in significant economic downturns. The 2008 financial crisis serves as a stark example, where subprime mortgages—despite being of extremely low quality—were erroneously classified as AAA-rated investments, creating a façade of security that collapsed under the weight of high default rates.

Historical Context: The Roots of Misaligned Incentives

To fully understand the landscape of misaligned incentives, it’s essential to trace their origins. The roots of the subprime mortgage crisis can be linked back to legislative actions in the late 1990s, particularly the push by figures like then-President Bill Clinton and Congressman Barney Frank to promote homeownership among low-income families. By requiring mortgage companies to extend credit to these borrowers, the intention was to democratize access to homeownership. However, nobility by power grab often causes unintended consequences. This time, the proliferation of risky loans that were poorly underwritten and ultimately unsustainable caused substantial wreckage caused by politics while Barney and Bill pointed fingers at the banks. 

This scenario is not unique to housing. Similar misaligned incentives exist in other sectors, such as education, healthcare, and EV’s. The government’s backing of student loans has led to significant inflation in tuition costs, as colleges and universities capitalize on the availability of easy tuition credit to raise prices without regard to the actual value of the education provided. Likewise, in the medical field, insurance companies’ financial backing can distort the pricing of services, proliferated by consumer insulation from direct cost, causing unlinking of thoughts regarding quality, cost, necessity of care, and seemingly unrelated rising premium payments. Green energy proponents were all-in for $7500 tax credits for EV buyers while Elon musk was a green environmentalist, but now that he has switched teams Tesla dealerships are being vandalized and taking fire in a DOGE backlash.  If the beneficiaries of government inefficiency are protesting the loss of their punchbowl, all the better for me because lower prices give me a better entry point for excessive cash and the result of less wasted tax money and lower regulation will surely result in higher share prices and an economic boom down the road, reminiscent of Reaganomics.

The Current Climate: A Call for Reset

President Donald Trump has indicated an intention to reverse many of these misaligned incentives through DOGE and other initiatives. The transition, however, is unlikely to be smooth. As industries adjust to the removal of distortive incentives, we may witness significant disruptions, which could trigger a recession. Yet, it is important to recognize that recessions are an inherent part of economic cycles. What distinguishes one recession from another is often the catalyst event—the specific trigger that leads to the downturn. It most likely will not be a looming government shutdown, which is political code-talk for resist-negotiate-acquiesce.

Play Your Chips Properly

Investors often view their portfolio as a series of holdings, likening them to inanimate gambling chips. But the chips have a life of their own. They are better viewed as living organisms with their own leadership, systems, momentum, and strategy. When viewed as a gambling chip, investors often over-estimate the need to intervene and move their chips around. They lose sight of the fact that the leaders of these companies are experienced and understand their marketplace better than you ever could, and they are most often properly incentivized to look out for shareholders. I place more confidence in the leader of the Home Depot to navigate the nuances of an economic contraction than my ability to predict, sidestep, pay taxes, and re-enter with a favorable outcome. Better to have factored such outcomes as a variable to begin with and be resolute rather than be faced with constant adaptation, and the associated risks of error and near-certain tax friction.

While it is easy to conclude that one can predict such cycles and avoid harm by standing to the side, proper execution of that is vexing. Signals like the inverted yield curve are only accurate about half the time. Going to the sideline also has two other hindrances: discerning proper re-entry point and taxes on gains whether right or wrong.

Embracing Change for Future Stability

As we navigate the complexities of economic cycles, it is crucial to remain vigilant about the impact of misaligned incentives on market behavior. While the prospect of a painful reset may be daunting, it is essential to view it as an opportunity for growth and stabilization. Removing the punchbowl of government largesse, we can foster a marketplace that rewards genuine value and innovation.

Ultimately, the goal should be to create an economic landscape where incentives are aligned with reality, leading to fewer distortions and, consequently, fewer or less severe recessions in the future. Left unchecked, the proliferation of these wasted dollars would lead to far more punitive resets in the future. Understanding the lessons of the past and embracing the necessary changes in policy and practice can pave the way for a more resilient and sustainable economic future.

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