Graph comes courtesy of the Speculative Investor blog
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Like many of you, I am having a number of Zoom video discussions these days – more than I had imagined I would even at the beginning of this COVID shutdown. Zoom as a company is clearly benefiting from the current state of affairs, but they are one of the few. So in today’s blog post, I want to take a look at the impact of the COVID shutdown and the unprecedented response by the federal reserve to provide liquidity to the system to preserve the financial system to the greatest extent possible. As of the end of April, the US True Money Supply (aka the Monetary Inflation Indicator in the graphic above) shows that the first few weeks of the money printing orgy has raised the money supply by 20%.
That number on the graph shows that in the short period that the Fed has been reacting to the economic carnage, they have printed more money than in either of the efforts to save the economy during the DotCom/September 11 Crash of 2000-2001 or the Subprime Loan Crash of 2008-2009. By the time all of their liquidity hits the system in coming weeks or months, we should see a money supply increase that dwarfs either of the other two recent crises.
One of the tools the Fed uses to impact monetary policy is to make changes to the Fed Funds Rate. Fed Funds have no connection to longer term interest rates as those are governed by the interplay of buyers and sellers in the bond market. However, it is interesting to see on the previous graph that we have had a 35-year and counting downward trend in bond yields. There is a clearly recognizable channel within which 10-year treasury rates have moved until Fed Chairman Powell began raising the Fed Funds Rate, scaring bond buyers into demanding higher yields on longer maturities
For a short time, yields moved above the downward channel causing damage to both the stock and bond markets. Once Chairman Powell changed his positioning, rates fell precipitously in the bond market giving us a period where the yield curve inverted.
There was significant debate at the time between those who said that the inverted yield curve was forecasting a recession within the coming nine to twelve months just as it had in the past and those that said this time was different. The common refrain from the latter crowd was that there were no signs of any cracks in the economy and that it was growing too steadily to be derailed.
Graph comes courtesy of the Slope of Hope blog.
Economic Impact of COVID-19
Then came COVID, and the damage can be seen in the graphs below that reflect the immediate shutdown of the US economy. In the first graph, the number of persons employed fell roughly by 35 million virtually overnight. As the stay at home orders were leveled across the country, people deemed non-essential were told to stay home in order to prevent the spread of the virus.
Government programs were enacted that funneled money to the unemployed as direct financial support as well as to businesses to keep current staff employed, all part of the increase in money supply discussed above. However, any staff that were unemployed but re-employed with government program money will not show up on the graph until after end of May, if at all, given the growing number corporate bankruptcies that are being announced.
Additionally, the April Help Wanted Index of Financial and Business Professionals report from the Conference Board shows that many white-collar office jobs are disappearing. The crisis has shown that companies can get by with fewer people and less office space – say good bye to middle management, at least for the next few years.
The most recent announced unemployment rate was 14.7%. However most people do not understand that the self-employed who have lost their businesses are not included in this calculation. Economist Martin Armstrong states that his calculation shows that the real unemployment rate is closer to 30% when those self-employed who lost their source of income are included.
There is a calculation called U6 Unemployment that includes people that have dropped out of the workforce because they have given up on finding a job. For the first time in history, there were more people unemployed in the US than employed.
Three big questions: (1) are we developing a new permanent class of unemployed; (2) who will pay for Medicare and Social Security given the reduction in employment taxes; and (3) who will fill all the vacant office space and retail space after this is over?
Graph comes courtesy of the Slope of Hope blog.
White collar and retail are not the only sectors being impacted. The graph below shows a similar decrease in industrial production. When factories shut down, many will not reopen due to lack of financial resources or lack of demand for their products.
Graphs come courtesy of the Slope of Hope blog.
The graph above shows the impact on GDP. We are already nearing the worst levels of economic retreat seen in previous crashes.
Taking one more swipe at how to view the economic damage, Dr. Lacy Hunt from Hoisington provided the graph below.
The graph shows that per capita GDP is at the lowest since 1946 and the Great Depression. That is just an estimate through first quarter and a little bit of this quarter, but it is entirely reasonable to believe that per capita GDP could drop to the lowest level ever.
All of this tells me that the expectation of a return to pre-COVID normal life is unlikely. There will be millions of people that will have no jobs to return to due to either downsizing or corporate bankruptcy.
The Conference Board report discussed above states that 83% of the country’s consumption comes from sectors of the country’s employment that are impacted by the virus. That 83% of consumption equates to 56% of GDP being impacted by the virus.
Certain industries may never be the same (airlines, travel and leisure, commercial real estate, retail shopping, restaurants) and certainly will downsize at least for a few years if not permanently.
All of the reduced economic activity and employment negatively impacts corporate profits and ultimately stock prices. Right now, the stock market is divorced from the economy. It is moving higher based upon expectations for the country to reopen and a vaccine to be developed before year-end. At some point, investors will begin to let the new reality sink in and examine the values that they are paying for the stocks they are buying.
In the graph below, I have plotted the S&P 500 Index (red line) over the past 20 years with the S&P 500 P/E Ratio (gray histogram). You can see that the last two crashes showed large increases in the P/E Ratio of the collective companies in the index. Since the current crash happened at the end of the first quarter, the company earnings reports for that quarter were not as materially impacted as we should see when the second quarter earnings reports come out in July.
If we are going to have a retest of the lows, the July-August-September timeframe would be a likely candidate. It fits within the six-to-nine-month typical retest time and coincides with the publication of the stock market valuations based upon current stock price divided by published earnings.
Prior to the COVID shutdown, the earnings estimate for the S&P 500 was at $165 per share for 2020. No one knows where we they will end up at this point. I’ve seen people estimating anywhere from $110 per share to $135 per share. If those represent the range earnings, and if we apply a historic average P/E of 18 we get an estimated range of value for the S&P 500 of 1,980 to 2,430. If we apply a more recent average P/E of 20 that buyers say has been justified by lower for longer interest rates, we get a range of value of 2,200 to 2,700.
Looking at today’s reading on the index, we are showing 2,971, clearly higher than either of the ranges from the post-COVID earnings estimates.
David Rosenberg’s Perspective
Famed economist David Rosenberg is very bearish on both the stock market. He believes Q2 GDP will plunge (perhaps more than the GDP Now forecast above? He doesn’t specify). He states that we are in a depression, a prolonged period of weak economic growth. Long-term risk is to the downside for the stock market. Over history, bear markets show a pattern of significant market plunge, a big rally that can recover half to two-thirds of the initial loss, then a grinding decline that takes the market back to the lows or lower.
Rosenberg says that the Federal Reserve’s monetary stimulus is not the same as FDR’s stimulus, this time its only government providing life support through liquidity. There is a surreal diversion between Wall Street and Main St. with most public companies surviving the crisis but with a permanently changed business model using fewer employees, many of the rest working from home, and a further reduction in overhead from downsizing office space. Unfortunately, the bulk of small businesses will be positively impacted by the monetary stimulus and upwards of half will not reopen or will fail shortly after reopening. He believes that 20% of the crisis-related unemployed will be permanent.
His forecast is the economy and the stock market will be in recovery through the end of 2023. His best case is for L- or reverse J-shaped recovery in the economy and stock markets. Corporate earnings will not normalize quickly given unemployment levels and consumers avoiding public places until a vaccine is widely available. End of the recession will not happen until then. This will give consumers confidence to re-engage with physical retail businesses. Demand is key to the recovery, not just reopening the economy.
He sees a rise in the savings rate for both households and businesses. Both will have learned their lesson on not having money on hand for an emergency. This crisis will yield shifting consumer behavior patterns as people focus on what they need, not what they want. Public corporations will not soon return to heavy use of stock buybacks financed by low rate borrowings to boost stock prices.
From an investment standpoint, he does not rule out negative nominal bond yields before the recession is over. He suggests being selective in stock investments, overweight healthcare but avoid commercial real estate REITs. He remains bullish on bonds but believes the 35 year bull market is closer to the end than ever. His highest conviction investment is gold as a buy and hold strategy for the long haul.
Investment Strategy Summary
Here is the graph we have been keeping track of on the blog since last summer. With today’s closing (2,971), we have finally closed above the bottom of the Relief Rally Target Zone (2,954). This zone is key to knowing if we will break above the 200-day moving average (2,999), break through the top of the zone (3,027), and challenge the all-time high (3,393).
The Relief Rally Target Zone is also key to knowing if we instead follow the path I drew in March: a trading range that eventually retests the lows (2,191) before moving back to new highs in 2023. I still find it unlikely that we will move down to the Secular Bear Market Zone on the chart, but if the elevated levels of unemployment persist for the long-term, it is certainly possible.
Our strategy for investing our individual equity clients is best described as cautiously aggressive. As discussed in earlier writings, while the market was moving to new highs during the early weeks of the year, we were raising cash and locking in gains.
When the market was in crash mode, we were aggressively buying good companies that were trading below fair value but that should recover their stock prices quickly when the crash ends (large cap technology, biotech and healthcare, consumer staples, and COVID stocks that would profit from staying at home).
As the market has approached the Relief Rally Target Zone, we have gotten incrementally cautious again, using stop losses to lock in profits in companies we purchased as the market has moved up and down on its march higher.
Now, we are watching to see what the market is telling us in terms of its future direction. If we do break above the 200-day moving average, we will put some cash to work that was generated by the stop losses. If we break above the top of the zone, we will put additional cash to work. If we fail and head lower out of the zone, we will raise cash.
Famed economist John Mauldin’s recent newsletter included a quote by T. B. Macaulay writing in 1830 in reply to those in his day who were convinced that the then-current economic crisis would persist into the future:
“We cannot absolutely prove that those are in error who tell us that society has reached a turning point—that we have seen our best days. But so said all who came before us, and with just as much apparent reason… On what principle is it that, when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?’’
His point was basically that they were using linear thinking to extrapolate the current bad situation into the future, believing that the country had experienced its best days and that those in the future could not compare. Mauldin makes the point that “real world GDP, after inflation, is up over 15X since he wrote that. The cost of a candle in 1800 that would let you read, however dimly, for one hour, was six hours of labor. Today that same amount of light costs about 3/10 of a second of human labor.”
Every crisis inspires someone to innovate in some way that leads to progress. Just like the candle begat the light bulb, there is something today that will be changed forever. As investment managers, we have to make sure that we do not fall into the buy-and-hold fallacy of those who invested all of their wealth in making candles when the demand for that product was shrinking. The same situation came out of the economic malaise and endless recessions of the 1970’s, when many of the Nifty Fifty stocks that were buy-and-hold favorites now do not exist. Given the speed with which science and technology advances today, we have to focus our investment choices on companies that we believe will be relevant for whatever the average holding time is for the investment objective our clients have selected. The example of the need for Zoom to continue operating businesses, holding church services, attending school classes, and keeping current with family and friends during this time where we have been closed down shows this need to stay relevant and invested companies that provide a needed service now and in the future.
My expectation is that the technology, communication and healthcare investment sectors will continue to grow in importance to our world as well as in relative size of the available investable universe. Our portfolios will continue to be positioned so that they provide our clients with the highest relative returns that we can generate.
During this crisis, our portfolios have outperformed their index benchmarks by 600 basis points (6%) and are quickly erasing the damage caused by the recent stock market crash. Our active investment management has far surpassed the performance of the highly touted index funds, showing that in times of turbulent markets, having an experienced investment professional on your side looking out for your savings is crucial.
If you are invested in portfolios that remain materially underwater and under their benchmarks, we would happily discuss with you what we can do to help you preserve and grow your assets in our various investment strategies.