The stock market is currently working through its third "once in a generation" crisis in the past 20 years.
There was the Tech Bubble in the late-1990s that culminated in the bear market of 2000-2002. The loose-money policies pursued during that period arguably created the conditions for the inflating of the property bubble, which culminated in the Great Financial Crisis of 2007-2009, with levered subprime mortgages wreaking havoc throughout the globally interconnected financial system. And now, following a decade of near-zero interest rate policy, and a resulting wave of massive debt issuance by corporations (and governments), we are dealing with the fallout of the COVID-19 crisis.
The massive debt load incurred over the past decade is an important thread that we’ll return to.
First though, to quickly recap where things stand, we saw a -35% decline from peak to trough in the S&P 500 in Feb/March, followed by an incredible bout of liquidity and fiscal support from world central banks and governments, which has created an equally dramatic rebound in stocks. The Nasdaq, led by the handful of "FAANGM" tech giants, blasted through the 10,000 level for the first time ever this week. The S&P 500 and small-cap Russell 2000 indexes remain below their all-time highs by -5% and -13.8% respectively. But the markets have rallied incredibly from their lows of just 10 weeks or so ago, and have recently actually been showing signs of speculative frenzy of the type unseen since the late 90s’ bubble.
Factors driving the recovery
There’s little doubt the driving force behind the incredible stock market recovery has been the massive actions taken by global central banks and governments. As the chart below shows, these actions quickly pumped the equivalent of 23.6% of global GDP into the economy. Or more specifically, the intent was to pump it into the economy. But as we saw with prior QE programs, a huge amount of that has been funneled directly into financial assets, pushing prices rapidly higher.
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Prior to COVID-19, one of the hot political topics was the idea of "MMT" — Modern Monetary Theory — which can be briefly summarized as the idea that central banks can directly monetize the spending of governments without negative consequences. Proponents would argue that’s oversimplifying it, but that’s the big idea. It was controversial just six months ago, but it’s basically become mainstream — as in, we’re doing it already. With the U.S. federal government running deficits of $4 trillion this year, the Fed is cranking the liquidity and has sent the money supply soaring.
It’s not just the Fed, obviously, as the chart above shows. The European Central Bank’s balance sheet now stands at 47.5% of the Eurozone’s GDP. The Fed’s balance sheet is roughly 33% of U.S. GDP. And the Bank of Japan, the OG (i.e., the original) of creative central banking, has a balance sheet of 117% its GDP. Unfortunately, Japan’s experience over the past 20 years — which has been confirmed by the ECB’s experience following the same path over the past decade — is that rather than being stimulative to economic growth, these massive balance sheet expansions have been a drag on growth. There’s no reason to expect that dynamic to be different now that it’s being applied to the USA.
That said, there’s no question part of the market’s recent strength is due to legitimate recent strengthening of the economy. The unprecedented steepness of the decline always implied some degree of a "V" shape to the recovery, which optimistic eyes have greeted in recent weeks as the global economy has gradually reopened.
Last week’s surprising +2.5 million improvement in the payroll numbers was the first significant positive data point suggesting the worst of the economic damage is behind us. That said, as the chart below shows, last week’s number obviously requires quite a bit of context, given the depth of job destruction that preceded it. But if you squint, you can see the V.
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Still, it’s clearly a start, and the market was expecting further losses in May, so it qualifies as unexpected good news. Many other measures point to people getting out and restarting their economic lives again in recent weeks. And the market has seized on these optimistic signs and decided to look ahead to the better future it hopes isn’t far off in the future.
The big issue at this point is that while there are encouraging signs being generated from the reopening, they don’t tell us how far this economic recovery will carry. The trajectory from such a massive decline was bound to be steep. But how far should that be projected to go? All the way back to pre-COVID economic activity levels? In bidding stock prices back to the levels seen immediately pre-COVID, that seems to be what the market is saying is appropriate. And perhaps it is.
The reality is the stock market always rises before the end of a recession, as stocks anticipate the better times ahead. However, bear-market rallies have also been a feature of every historic bear market (until this one!), and the two are virtually indistinguishable in the moment. It’s only with the benefit of hindsight that we can see that a particular rally followed through to end the bear market, whereas all the prior rallies failed and rolled over.
The threat in the current environment is that if the economic recovery stalls out at something less than 100% of its prior output, that could create significant problems for corporations and stock prices. On its face, it’s not hard to see that many businesses aren’t viable at 85% or 90% of their prior revenues. Most restaurants, for example, have profit margins well below 10-15%. Many businesses that were profitable at prior levels of economic activity are unprofitable with even slightly lower revenues. A "V-shaped recovery" is great news, but ultimately a failure if it levels out at 90% (or whatever) of prior activity.
So how likely is that outcome? Unfortunately, it seems reasonably likely. Here’s an economic recovery projection from the Congressional Budget Office:
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The CBO doesn’t see economic activity getting back to 2019 levels until 2029! Gulp!
The OECD is more optimistic about the global economy overall, but even their optimistic scenario doesn’t see world GDP getting back to 2019 levels until 2022.
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Potential market paths
At this point, the stock market is clearly buying into the "return to growth" story. If we knew the worst was over and there weren’t going to be any substantial setbacks moving forward, it might be reasonable to suggest stock prices should return to the levels they were at before the recession started. But the reality is we know there are challenges and threats now that we weren’t (at least explicitly) aware of then.
While nobody has any realistic idea what corporate earnings will be like 6-12 months in the future, we know they’ve been crushed recently. With prices approaching the levels they were pre-COVID, but earnings dramatically reduced, the S&P 500’s P/E ratio has soared to 25.6, well above the average of just below 17 the index has sported over the past 20 years. This isn’t necessarily inappropriate, given that the market is clearly "looking through" the current earnings shortfall and assuming an eventual return to normalcy.
But make no mistake, stocks don’t get less risky as prices rise. They become more risky. This is the same message we were saying immediately before the bear market — a lot of positive future is being priced into stocks at these levels. And whereas six months ago we didn’t know all the potential headwinds the market was about to face, now we can see many of them clearly.
One of those potential headwinds is the less-than-100% recovery, and this is where we pick up the thread from the beginning of the article about the massive corporate debt loads. Debt amplifies both positive and negative outcomes. If revenues don’t come all the way back, profits disappear but those debt payments remain. The first step to address that is typically layoffs, which clearly adds to the broader economic troubles that are keeping the recovery from bouncing all the way back in the first place. If cost-cutting can’t bring expenses down to match revenues, the potential exists for many businesses to become insolvent, with bankruptcy the only recourse to get relief from their debts.
The market is most assuredly not pricing that scenario in at this point. Unlike the liquidity-driven "event" of March, insolvency tends to unfold in a slower, grinding process. And it may not play out this way at all. But with many of the economic props set to expire in the next couple months, it’s too early to rule it out and assume the coast is clear. By the end of July, the extra unemployment benefits are scheduled to cease, and much of the mortgage/rent/auto-loan forbearance may be over as well. How much demand loss comes from that, especially given that roughly 68% of those receiving unemployment now have been getting more than they were making at their previous job (meaning they’ve actually had more discretionary income in recent months, rather than less)?
So the risks to the upward path stocks have been charting are clear as we move into the second half of the year. Of course, the elephant in the room is what we started off looking at — the massive support being provided by central banks and governments. History is pretty clear what the end game is for governments that get in over their heads with debt and other fiscal problems: increase the money supply and try to inflate their way out. It can work for a while, but ultimately fails as the inflation renders the currency worthless.
I think we’re a long way from that end game, but I absolutely believe the Fed is going to keep cranking the money supply higher in an effort to keep any emerging problems at bay. I don’t think anyone knows the outcome we’ll get as a result, particularly as we haven’t even addressed the potential for COVID to pop back up again. But just as we can’t rule out another downturn due to the headwinds facing the real economy, we can’t totally rule out the tidal wave of liquidity carrying stock prices higher either.
Speculative fever and the role of the SMI strategies
As if market conditions weren’t crazy enough, there’s been a stunning surge of speculation since the March lows as millions of new "investors" have flooded into the market. The Wall Street Journal ran a terrifying article today about it (behind paywall), detailing the gambling these new accounts are doing on, among other things, bankruptcy stocks. Hertz stock fell to $0.55 per share on May 26, four days after it filed for bankruptcy. Over the next two weeks, its stock soared to 10x that level ($5.53) before getting cut in half to $2.76 over the past 48 hours.
There are dozens of examples like this. It’s the first time in 20 years I’ve been reminded of the retail speculative fever seen in the late-1990s. I never thought I’d see it again, and certainly not inside of the worst economic crisis/recession of our lifetimes. But it’s just the latest in the series of incredible market oddities 2020 has thrown at us. (Read this story if you doubt the parallel to the late-90s’ madness engulfing the speculative fringe of the current market.)
The SMI strategies will help us navigate these incredibly challenging market dynamics, and we’ll continue to write more about that as events unfold. The conservatism built into our models has caused our portfolios to lag on the way back up as the market has shot higher. Our process has already begun to push us back into risk assets as their momentum builds, which is going to be uncomfortable given the still-clear risks.
It’s important to recognize there are risks in both directions — economic downside risks, but also the risk of getting left behind if the tsunami of liquidity continues pushing equities substantially higher. While we’re unlikely to navigate these cross-currents perfectly, at least the SMI strategies provide us with a framework to be able to continue investing productively within a very risk-sensitive framework. It’s important to realize that it’s okay to be conservative when all the normal rules of the game appear to have been temporarily suspended.