When evaluating a stock as an investment target, many professionals conduct an analysis comparing the upside potential of the position relative to its downside risk. Ideally, you’d like to find a company with a great deal of upside potential (e.g. upcoming profitable operations, temporarily undervaluation, and other catalysts for improvement) and defensive attributes (e.g. substantial assets on the balance sheet, low debt-to-equity ratios) to mitigate downside risk. Some managers set an arbitrary target (let’s say 2X-to-1X) of upside potential to downside risk as a requisite for investment. Macro-level economists evaluate the entirety of a country in the same way. In other words, if we consider the entirety of our collective capitalized stock market, what’s the upside potential and what’s the downside risk? Of course, collective equities have historically had a fantastic potential for upside over the long term, but that ratio of upside-to-downside changes over time as valuations get realized and reapplied.
So let’s just consider the short term generalities for a moment. On one-hand, there are bullish advocates for an even greater upside potential. For example, President Trump suggests that the Federal Reserve’s steady increase of rates over the past few years has muted an even greater upside potential which could arrive the moment the Fed reverses course and cuts key interest rates. Arguing the Fed “doesn’t have a clue”, President Trump would like to see rate cuts as part of a campaign to devalue the dollar, increase US exports, and soften monetary slowdown due to his tariff campaign.
On the other hand, there are bearish Wall Street firms and analysts who believe the short-to-medium term downside risk are under-appreciated. For instance, Guggenheim’s Macroeconomic research team notes deterioration in leading economic indicators including the yield curve inversion, year-over-year fiscal tightening, strained corporate credit, and limited potential policy corrections. Their proprietary recession probability model suggests a potential bear-market of -40% in the despite only a moderate pullback in real economic growth (starting first half of 2020). Other models suggest roughly even odds for a GDP pullback over the next 12-18 months.