Introduction
.
At about 2,900, the S&P 500 is only 15% off its all-time high and down just 10% for the year, but the starting points were arguably lofty levels. At its low, the market fell 35% from its intraday peak of 3,394, which is slightly more than the median bear market of 33% during the last seven recessions. The current rally implies all is now fine and well, coronavirus is just a blip, and the economy will be off to the races sometime soon. This may be hopeful thinking.
.
How Long Will This Go On?
.
At 1 million people testing positive for coronavirus in the US, perhaps only 2% of the population has had the disease. This assumes 7X as many are asymptomatic or did not get tested as were tested and are positive, but I’ve seen estimates that have ranged from 0.3X to greater than 10 times. At a contraction rate of 210,000/day (30,000 reported times 7), it will take 800 more days for the US to achieve herd immunity, assuming this requires 50% contracting the virus if each person transmits it to two others. Hopefully, a vaccine is available before then.
.
The Government to The Rescue
.
Liquidity saves the day. US fiscal stimulus is about $2.5 trillion (more than 10% of GDP) and may be rising, which dwarfs the package (TARP was $831 billion) during the Great Financial Crisis (GFC). The Fed may double its balance sheet to $8-10 trillion from $4 trillion, and it broke new ground buying fallen-angel risky high-yield bonds, supporting the municipal bond market, and by lending to mainstream firms (with the Treasury picking up the losses). The speed of these actions was incredible, which explains the quick rebound in stocks. The market appears to be cheering every bit of good news on new coronavirus cases plateauing and the states’ reopening plans; prices seem to imply a V-shaped or skinny U-shaped recovery.
.
Will the Economy Get to a Quick Start?
.
Coronavirus may have shut down 29% of the economy and at least 30 million have lost their jobs in the last six weeks, or more than the number of jobs created since the GFC. Typically, Fed liquidity/rate cuts during a recession encourages firms to borrow and this stimulates growth and rehiring. Government spending also gets people back to work. Today, borrowing and government spending is just offsetting short-falls and keeping firms afloat. Normally, the Fed/government is like the good car that jump starts the dead car (recessionary economy) so gets it back on the road (to economic recovery). Today, the battery is so dead that the big jolt of electricity appears to only be providing enough juice to run the radio. Organizations continue to lay off people in droves, but maybe some will be hired back. They are at least required to do so if they borrowed from the US Paycheck Protection Program (PPP). The current fiscal stimulus will get firms through a few months. Will the government be willing to fund firms even longer as debt mounts if the economic recovery moves in waves of starts/stops?
.
| Figure 1: Bull and Bear Cases |
Bull Case
|
Bear Case
|
Are You Willing to Go Out? To Work?
.
While states are beginning to open, are you willing to go back to work, go out to eat, and go to a movie? Will these firms even be around? The US Paycheck Protection Program’s provision for small business was quickly depleted (now replenished), but perhaps 80% of applicants are still waiting for funds. Many small businesses may only have cash for a few weeks of expenses. If you go back to work and someone tests positive and transmits coronavirus to you, does the firm have legal liability? How will the firm protect you?
.
Testing
.
Testing is still problematic. The Trump Administration says it has enough tests for 2% of the population. That’s seems pretty light, but maybe it will cover health care workers. It does not seem adequate to reduce fears. Antibody tests to see if you have had the disease are coming. Roche said that it will have high double-digit millions per month by the end of June, and Abbott may ramp up to 20 million per month by that time. However, even if we find out that 2-4% have had the disease, will this really get people back to work? We have antibody tests now, but the issue is they can give many false positives. If only 5% have COVID-19 and the test is 95% accurate, 50% could receive a false positive result. This means people could go out and operate as if they are immune, get coronavirus, and transmit it to others. If news of this gets out, who would then trust these tests?
.
Tracking
.
Tracking those who have COVID-19 is about non-existent, but Apple and Google on working on this. In China, people are tracked by their phones and have red, yellow, and green lights. In the US, citizens may not allow themselves to be monitored this way and their behaviors governed by “lights.” We also need armies of people to trace and isolate those who were in contact with people having coronavirus (Attorney General Barr says he is watching states for violations of rights). Unfortunately, those who are most likely to allow tracking may also be those who are most careful and we least need to track. According to one estimate by Oxford University, 56% need to opt in for phone app-based monitoring to be effective in the UK. Plus, the tracing effort will be led by states and localities, but they have a budget crisis and must balance their finances. Although, it’s quite possible the Federal Government will provide further help to states.
.
Treatments
.
Good news on Gilead’s remdesivir treatment was released on April 29 and the market rallied. If this works, people may be more willing to go out if they believe they will not die if they end up in a hospital. Although, since this is delivered intravenously, you’d need to be pretty sick and in a hospital to get it, so it is not a silver bullet. Still, many smart people are working very hard on treatments and we could have good results in a month or a few.
.
While the number of new cases appears to have plateaued (it just recently started to go down), the number of daily deaths is declining, which means doctors are getting better at treating coronavirus patients. Maybe this will encourage people to go out; however, perhaps many out of work will not want to go back to their jobs since perhaps ½ of the people who lost their jobs may make more unemployed ($978/week) than employed ($957), at least until unemployment benefits run out.
.
Prevention
.
Social distancing works, and the plateauing numbers prove it. Data shows that we can reduce the odds of catching the disease further if everyone wears a mask. A former student of mine who lives in Beijing texted me 1-2 months ago and said to make sure to wear a mask. While Americans may not allow the government to control them with lights like in China, gladly wearing a mask voluntarily, or because of peer pressure from others, or simply because of herding tendencies where people do what others are doing, could encourage all to wear one and have a positive impact on this crisis. Generally, I’ve seen news that indicates that wearing a mask mostly benefits the person you meet more than yourself, but we need to get R0 down and making sure those who are asymptomatic do not transmit it to others is important. If this is not enough of a reason to wear a mask, please consider that even if a mask is only 50% effective, if each pair of people who come into contact wear one then this reduces the odds by 75% of contracting COVID-19 which can reduce R0. The good news is that reducing R0 lowers the percent of the population who need to contract the virus to achieve herd immunity. The bad news is that it slows the spread (this is still good for hospital care) and it takes more time to get to herd immunity levels.
.
Vaccine
.
Many firms are working on a vaccine, but firms have also worked for years on cures for Alzheimer’s and coronavirus is somewhat novel. If a vaccine is not safe, it could kill more people than it saves. A couple weeks ago, I was on a conference call and one of the speakers noted that there were 1,300 trials (this is a guess based on my recollection) being conducted related to coronavirus vaccines and treatments. I’ve read that it is not wise to bet against human ingenuity, and I tend to agree. In this letter to shareholders, Buffett said, “From a standing start 240 years ago – a span of time less than triple my days on earth – Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers.” Still, a vaccine that arrives in a year to 18 months will not get the economy back to full potential anytime soon.
.
A Reminder of the Past
.
We almost had a recession (in my opinion, we had a manufacturing recession) in 2014-16 when WTI oil prices fell from above $100 a barrel to under $30. Last week oil fell to -$37 at contract expiration due to problems offsetting long positions with shorts to become net neutral (if one is long at expiration, one has to take delivery of oil, and storage is running out so there were few buyers). This low of oil prices would normally be bad enough to potentially drive the economy into a recession. Coronavirus did not have to help. Of course, low oil prices boosts discretionary spending power and helps to keep inflation down, so it also has some positive impacts on the economy.
.
Opening May Not Be Easy
.
It’s perhaps easier to shut down operations that to open them back up. Many supply and labor chains are broken. Perhaps firms that closed can get back to 50% capacity soon, but that still leaves GDP down 15% on an annual basis. Many retailers, restaurants, and leisure businesses will be at lower than 50% capacity for some time. Boeing’s CEO expects it will take 2-3 years for air travel get back to last year’s levels.
.
Distorted Asset Prices
.
The Fed is distorting asset prices with its liquidity injection into the economy.
.
For instance, high-yield/junk bonds yield only 8%+. In the GFC, default rates rose to the mid-teens, and assuming only a 25% recovery rate, this means you could lose money investing in average high-yield risky bonds this year. The Fed assumes 10% overall losses, picked up by the Treasury, on its lending. Losses will surely be higher in junk bonds than the Fed’s average loan. Starting at 8% yield for junk bonds, this means the Fed is anticipating at least 18% default-related losses for an overall loss of -10%. Are you willing to invest in this asset?
.
Before the Fed provided liquidity, average yields on high-yield bonds were skyrocketing and rose to 11%. If yields are now too low, investors have to move up the risk spectrum to earn decent returns. Carnival recently issued 11.5% bonds, down from 12.5% expected due to high demand, and down from 15% from what hedge funds and others had offered. The Fed indirectly saved the company a lot of interest expense.
.
Since 1997, stocks tended to bottom with trailing 12-month earnings (TTM), not before, and it took ten months to 50 months for earnings to rise beyond prior peaks (see figures 2 and 4 – left graphs). Firm market value tended to bottom modestly ahead of EBITDAR, and it took two to 11 quarters to get back to a new high (see figures 3 and 5 – right graphs). Because of various behavioral biases, investors typically extrapolate recent trends and don’t forecast turning points too well, at least not too far ahead. Price action’s lead to profit changes varies over time: in the 1980s the market often moved opposite of profits, in the 1950s and 1960s the market rallied ahead, and in the 2000s it has been closer to coincident.
.
However, the market’s lead today is substantial. 1Q 2020 is worse than 1Q 2019, 2Q 2020 will be drastically worse than 2Q 2019, and perhaps, or hopefully, by 3Q and 4Q we will be slowly getting back to normal but still much worse than 2019.
.
The Fed is a buyer, and it is huge. Plus, it buys counter-cyclical. Right now, the Fed is buying more bonds than are being issued and the money it is spending must go somewhere. Cash is rising, but so is the stock market. Normally we can rely on history (e.g., the relationship between profits and the stock market) as at least a partial guide. Mark Twain said, “History doesn’t repeat itself but often rhymes.” However, history is not even rhyming today and maybe it shouldn’t. Coronavirus, and the Fed’s and central government’s very substantial and quick reactions, are unprecedented.
.
.
Is the Market More Than Fully Valued?
.
Even if earnings and EBITDAR recover to their prior peaks and even if we suggest the market was not overvalued at that level (before the virus hit, the Shiller cyclically adjusted P/E was essentially at its highest level versus the 10-year Treasury bond since 1881, and now it is where it has never been before), would the rebound in the S&P 500 back to is prior high be reasonable? Probably not. I agree with Keynes that “The market can stay irrational longer than you can stay solvent,” so while I argue below that the market is probably overvalued, this is not necessarily a reason for the market to go down anytime soon. It is a reason to be skeptical of the rally, but the rally is likely Fed induced and fighting the Fed is normally not a good idea.
.
Possible Negative Repercussions That Drive Intrinsic Value Down
.
Corporations will be laden with even more debt following this crisis, and they already levered up beforehand as they typically do over each cycle. This financial risk could raise the cost of equity capital, driving down valuations. It may also reduce investment and risk-taking. While consumers and banks delivered following the GFC, the government and corporations levered up. Borrowing may lower future consumption as it crowds out spending as people pay off liabilities, which is perhaps one big reason why real GDP growth was so slow following the GFC. What if corporations deglobalize and decentralized supply chains? This will add to costs and reduce profits that can be invested. More debt, higher financial risk, and lower profits could lower growth forward, which means we should value companies lower.
.
Furthermore, if monetary growth is not cut off quickly as the economy recovers then this could result in inflation. Powell says he is not worried about it, which worries me as he could be underestimating the risk.
.
- Money supply times the velocity of money, or how many times it is lent in the economy, equals inflation times real GDP. If money supply growth is not slowed and velocity is not reduced (the Fed boosted velocity by dropping banks’ required reserve ratio to zero to support lending) when real GDP growth improves, then inflation will materialize. Powell said on April 29 that “It may well be the case that the economy will need more support from all of us if the recovery is to be a robust one.“ This means that he is not expecting the Fed to take the foot off the gas pedal.
- The movement to populism may get a further boost. The wealthiest 10% owned 84% of all stocks in 2016, so they are the ones directly benefiting from the Fed’s support of the stock market. Coronavirus has disproportionately hurt the lower income parts of the population as they were the people most likely to lose their jobs (i.e., they often work in retail, restaurants, etc.). Perhaps this is part of the reason why the stock market is not going down – those who own most of the stock market are not impacted by their own job losses. Populism may rise. Jobs may come home. Wages could rise, which drives up inflation. Possibly paying more for supplies if they are sourced “at home” or from a more diverse supplier base to reduce risk will drive up expenses (without discount bulk buying and other logistical economies of scale), and in the end, corporations may boost prices to offset costs pressures.
- Of course, if the economy opens up and people demand products and supplies are still limited (because people are out of work and firms are slow to rehire them), then this naturally drives up inflation.
- Furthermore, oil prices are low and the dollar is high (see figure 9) as it is in limited supply and is a safe haven asset (see What’s Up (or Down) With the Dollar?). If the economy turns around and oil rises and the dollar falls, inflation could surprise (see inflation model in Positioning the Cycle).
.
Of course, the coronavirus crisis is accelerating the movement to the internet economy and disruptive technologies (Amazon and Netflix) and to greater price discovery and competition (Amazon), which helped drive down inflation over the past decade+ and could offset some of the possible inflation pressures noted above. Also, an aging population, debt constrained spending, and low capacity utilization could also offset inflation tendencies. Finally, unemployment may be high for some time, which may limit wage gains.
.
Then, we have the Fed’s massive balance sheet to consider. We don’t have history to help us understand how that may unwind, which adds to systematic risk which negatively impacts valuation. On the other hand, even if the equity risk-premium rises, low rates forever may help offset and keep the rise in cost of capital at a minimum.
.
We are putting much faith in the Fed Reserve. It is powerful, but not always correct. I’m sorry to have to remind you of this but didn’t Greenspan warn of irrational exuberance during the internet bubble that ran on several years longer as money supply took off, and didn’t Bernanke suggest that the housing bubble was not systematic in this CNBC interview in 2005? I’d argue that Bernanke and Yellen fixed the financial crisis by keeping borrowing rates low which allowed corporations and the US Government to lever up. Sadly, that’s ironic. We solved a financial crisis by allowing people to borrow more at lower rates. At Powell’s press conference on April 29, he said, “this is not the time to act on those concerns,” when addressing the rising debt. I agree, but I also argued that the tax cut was dangerous because we should have been saving for this rainy day. Normally, the Federal deficit to GDP improves during good economies, but it had been worsening before this crisis.
.
.
This is so important that I transcribed it for you. On April 29, Powell also said (at 40 min 49 seconds if you care to listen), “In terms of the markets, our concern is that they be working. We’re not focused on the level of asset prices in particular. It’s just markets are trying to price in something that is so uncertain that it is to be unknowable, which is the path of this virus globally and its effect on the economy. That’s very very hard to do. That’s why you’ve seen volatility the way it’s been. The market reacting to things with a lot of volatility. But what we’re trying to assure really is that the market is working. The market is assessing risks, lenders are lending, borrowers are borrowing, asset prices are moving in response to events. That’s that’s really important for everybody, including the most vulnerable among us. If markets stopped working and credit stops flowing then you see very sharp negative, even more negative, economic outcomes. I think our measures have supported market function pretty well. We’re going to stay very carefully monitoring that, but I think it’s good to see markets working again. Particularly the flow of credit in the economy has been a positive thing as businesses have been able to build up their liquidity buffers, households have been able to be home. People have been home concerned about their jobs, but not concerned about the financial system collapsing as they were in 2008 and 9.”
.
For an investor, this quote means he is ok with distorted valuations as long as credit is flowing.
.
I would argue that the market is not working – Powell seems to disagree – if there is not natural price discovery and allocation of capital to the best risk-reward outcomes. Without this, capital is destroyed long-term. Maybe this is the price of the rescue, but that means that the overall valuation of the market should be lower. Look at how much capital was destroyed in the internet burst and the GFC through misallocation of capital to unwise risks beforehand. Haven’t we learned already? You probably cannot fight the Fed and win, but investing in market where a huge investor disregards fair values means you need to be compensated for more risk, which means the value of assets should decline.
.
Some people may claim that the Fed’s actions are appropriate and that everyone deserves saving – even those companies with high-risk stocks and bonds that are getting a lift – since nobody could have predicted coronavirus. Well, Bill Gates did. Plus, this argument fails to recognize the risks that many, but not all, firms and investors gladly took to levered up. Risk is called risk for a reason. One may earn above-average returns, but this is just “on average” as sometimes one loses money. To many, it was quite apparent that the economy was in the latter phases of its cycle well before coronavirus. The stock market dove in late 2018 on these fears. Firms which were not prudent and are being saved now could have taken this into consideration with their spending, share buybacks, and growing leverage, and investors in them could have incorporated this with their choices. Should we reward unwise risk-taking? Isn’t there a moral hazard if people learn that that the Fed will always save them if they make unwise choices? Everyone will pile in to take risks if they know their losses are quite limited. Capital will go to risky investments that don’t end up making economic value added (EVA), which is the key to returns and creating corporate value (see Profitability Drives Value). In the next recession, we also risk the Fed being politicized and ostracized if they do not rescue bad actors again.
.
Clearly, if a firm goes bankrupt, then this could cost people jobs who had no influence on the decisions that caused the company’s demise. This does not seem fair. One study found that by two years after bankruptcy, the average decline in worker wages was 30%, and less than ¼ of the employees of a bankrupt firm stay with it by three years after. Although, this study also found that employees at higher levered firms were paid higher wages. On the other hand, a guest on CNBC a few weeks ago argued (I am assuming he was not referring to a Chapter 7 liquidation bankruptcy) that the majority of the workers maintain their employment during bankruptcy. If you have insights on worker losses during bankruptcy, please email me.
.
While it may not be fair if one loses his/her job in bankruptcy from unwise decisions that he/she did not make, perhaps letting that firm fail is still best for overall employment. Assume the bankrupt firm was imprudent with owners’ capital. If this capital was not wasted, it could have been better allocated elsewhere to grow prudent firms that could hire workers who are displaced and grow to even employ more people. Thus, in the end, saving an imprudent firm which has a liquidity situation costs more jobs than it saves.
.
Right now, given the Fed’s aggressive liquidity, prudent firms and investors who marched forward with caution are being penalized for their wise choices over the past few years. If we let imprudent firms and investors fail, then the prudent firms could grow to take market share from the poor actors and prudent investors could buy assets cheaply and earn a decent return for their risks. Unfortunately, this is not being allowed. For example, Oaktree Capital Management was part of the group of firms that was negotiating to lend to Carnival at 15% but lost out to an oversubscribed deal at 11.5% after the Fed stepped in and provided liquidity. Is it fair for this firm, which had the mantra “move forward but with caution,” as it saw excesses reminiscent of late cycle dynamics, to not earn proper returns for the risks they are taking on a loan to a firm such as Carnival? I assume the firm did not go for the deal at 11.5% or would have been much less pleased with this rate. This firm and others like it are being punished, as are savers who are dependent on interest income that is now lower since rates have gone down.
.
Finally, what happens if the Federal Government decides again to deal with the deficit? Will this put on the brakes to an otherwise improving economy? Are tax hikes in store for the future? This could limit future profits and drive down market valuations as well.
.
To end this section on a positive, please let me offer a few reasons to be optimistic and a reason that corporate valuation could rise. Crises may be catalysts for change. If the change is for the better to make firms (and governments) more productive, more resilient, and more risk-aware, then this could lead to better decisions in the future. This could raise profits, improve the allocation of capital, boost growth, and lower risk, which all positively impact valuation. For instance, this crisis is accelerating digital adoption, which can make firms more efficient. As another example, many have learned they can work effectively from home, which may mean less wasted commute time and perhaps a higher quality of living. Although, offsetting this benefit of working from home is that the home now becomes the workplace, which means you may need to leave your residence to feel relaxed.
.
.
Still Doubters in This Unhealthy Rally
.
While the S&P 500 has recovered much of its losses, market internals suggest fear is alive and well. Assets that typically outperform during economic recoveries are not and those that do well during recessions still are.
.
Tech/quality (high ROE)/FAANG outperformed during the rally and before the market swoon. Microsoft said that it saw two years of digital transformation in two months, which at first appears positive to its outlook as this just fuels the trend, but it could also mean future sales are pulled forward. Netflix had record paid subscriber growth. What else is someone going to do but watch Netflix right now, but sales may have been brought forward.
.
There are doubters. Small/value stocks underperformed large/growth this year (figure 7), cyclicals underperformed defensives (figure 8), gold and the dollar are up (figure 9), oil and other commodities are down (figure 9), and the rate on the 10-year Treasury Bond is down (figure 10). AAII sentiment is bearish (figure 11), short-interest is high (figure 12), hedge funds net exposure is low (source: Evercore ISI), and cash (bank deposits) is high. The one big “bull”/who is buying is the Fed, which is supplying liquidity (cash) that must go somewhere.
.
Large-cap growth stocks outperformed small-cap value the last few years (figure 13). The underperformance is similar in magnitude to what occurred during the internet bubble. To be fair, this time large-cap growth stocks make money, and small-cap value started this underperformance following a large rerating of their valuation multiples up relative to large-cap growth (they are trading at a large discount today).
.
Bearish sentiment means that a positive surprise could be met with a rising stock market. My cautionary call in January 2018 in Positioning the Economy – at today’s S&P 500 levels so the market has gone nowhere for over two years – and then bullish stance in January 2019 in The Wonderful Stock Present Under the Christmas Tree – after the 4Q 2018 correction and at the start of the rally – were predicated on sentiment being extremely high and low and susceptible to negative and positive surprises at those times, respectively. If investors get bullish and back in, the rally could continue. The last few days before today small stocks outperformed large, with the winning large stocks still advancing. On the other hand, if the generals (large/growth/quality) leave the army behind (small/cyclical/lesser quality), then this is not a healthy stock recovery and could fail. Look what happened in 1997-2000 with the tech bubble that left everything else behind. It eventually burst (see black line in figure 13 for large-cap growth stocks which declined after early 2000).
.