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Working over twenty five years in America’s financial sector for both large and small companies and now as the director of research and strategy for a $10 billion institutional investment fund manager, I have experienced firsthand what drives economic growth, what stimulates job and wage growth. And I’ve seen up close both how the financial sector operates and its role within the economy. My experience also includes advising the Chicago and Washington, D.C. districts of the U.S. Federal Reserve as well as CalPERS, the largest U.S. public pension fund.
Stock market prognostication is something I typically highly recommend against doing, yet I do so below. Why?
First, because I perceive an unusually high level of risk in today’s equity markets. This is based on the inconsistency between today’s stock market valuations on the one hand and on the other hand today’s depressed economic environment and especially because of the highly uncertain vaccine development and distribution timeline.
Second, because the risks inherent in today’s equity markets so far have not been appropriately highlighted in the financial media outlets targeting investors.
If after reading below you are more aware of the heightened risk
in today’s equity markets, the primary objective in writing this will
have been achieved. The predictions are secondary in importance as they
are merely the vehicle to communicate the risks in today’s equity
Stage 1: Frenzy
Equity Market Frenzy
Equity markets have been in a frenzy since their March nadir. As of the market close Friday the 19th,
the NASDAQ index is above, yes above, its February peak. The S&P
500 is less than 10% below its February high while the DJIA is within
12% of its high. This occurred in four short months after the February
peak in an environment of historic job losses, double digit
unemployment, and ongoing weekly million plus unemployment insurance
Shelter at home policies combined with consumers’ initial respect for
the risks associated with COVID-19 left consumers in a state of
isolation and economic hibernation. After numerous weeks of isolation,
some consumers couldn’t take it anymore and left their homes with great
enthusiasm creating a frenzy of activity.
After seeing its average weekly requests for driving directions cut by 1/3 in Texas, Apple driving direction requests surged subsequent to the reopening and as of June 19th stand at 155% of pre-pandemic levels.
Source: Apple Mobility data
Not surprisingly, increased consumer mobility led to increased
economic activity. Retail sales rebounded 17.7% in May. Consumers used
their newfound freedom to purchase automobiles, increase home buying,
and gleefully return to Las Vegas casinos. Topping it all off, initial
estimates indicate that a surprising 2.5 million jobs were added in May.
These all supported the view held by some economists that the best
analogy for the pandemic is a natural disaster and the view that the
economy will similarly bounce back quickly.
Adding to the frenzy, fiscal and Federal Reserve stimulus has been
unprecedented and received with both relief and glee. Consumers lined up
to deposit their stimulus checks while unemployment insurance
recipients gave thanks for the increased size of their weekly benefits.
After initially reporting the sobering opinions of experts that even
in a best-case scenario a vaccine would take 18, maybe 12 months to
develop a new, more optimistic story appeared. Reports that a vaccine
might be developed by the end of the year and available in 2021 began
dominating the news. More recently, some are even speculating a vaccine
might even be found by the presidential election.
Meanwhile, on-air stock market pundits and guests were validating the
fiscal and Federal Reserve stimulus frenzy as they confidently
proclaimed, “Don’t fight the Fed”, all while the outlets prominently
displaying their “street cred” to bolster the proclamations reassuring
viewers that now was the time to be in the market.
Media outlets have been scouring economic indicators for any positive
signs or even just less bad economic news and writing articles filled
with talk of an economic bottoming and multiple variations of headlines
along the lines of, “Signs of a V-Shaped Recovery”.
They hailed the 17.7% increase in retail sales hoping to bolster
consumer sentiment and investor confidence. This was done with very
little if any mention of the reality that retail sales remain down more
than 8% from their pre-pandemic levels, and rarely asking if May’s rate
of rebound was sustainable.
Source: U.S. Census Bureau
They reported on the slight rise in consumer sentiment while often
not mentioning that consumer sentiment remains very depressed.
Source: University of Michigan
Stage 2: Fear
While infection rates are improving in areas of the country hit
hardest first, infection rates are surging in many other states. The
surge in infections seemed to catch Wall Street off guard with stocks
declining nearly 7% on June 11th (only to be largely shrugged off in
subsequent days). This was despite basic logic showing the inevitability
of the resurgence in infection rates: If reduced circulation of people
resulted in reduced rates of infection…increased circulation of people
would result in increased rates of infection.
How bad is the resurgence in infection rates? Let’s look at the
FAACT’s, the FAACT states that is. These are what I call the FAACT
states: Florida, Arizona, Alabama, California and Texas. They
collectively have seen a near tripling of their seven-day infection rate
rising from under 25,000 cases before the reopening to more than 72,000
cases as of the last seven days. These five states alone now comprise
45% of total weekly U.S. infections, up from 12%.
Resurgent infection rates have resulted in fear-laden headlines
including among others, “Experts weigh in on which states are primed to
be the next COVID-19 hot spots” and “Texas announces record number of
hospitalizations as its daily death toll rises”.
Source: USA Facts
Stage 3: Fizzle
From Merriam-Webster: Fizzle – to fail or end feebly especially after a promising start
Note that the factors below underpinning my expectation for an
economic fizzle after a short-lived rebound do not include a second wave
of infections in the fall. If a substantial second wave were to occur
in the fall without widely effective and widely available viral
treatments the economic fizzle could quickly transform into a freefall.
Factor 1. Reports of early signs of a strong economic rebound are misleading.
Focusing on the percentage change from depressed levels gives viewers
an incorrect perception of the health of the economy. First, the
comparisons are to highly depressed levels. Second, mathematically, even
a rebound equal in percentage to the decline leaves economic activity
well below the prior levels.
Factor 2. While some areas of the economy have been able to notch
healthy early recovery rates, that doesn’t mean the early rates of
recovery can be sustained.
The few early signs of an economic rebound are due to pent up demand,
not a strong consumer able to sustain the early rates of recovery being
trumpeted as signs of a “V” shaped recovery.
The number of renters paying with credit cards in May was up 58% from
February. Millions of Americans remain unemployed and/or with reduced
Factor 4. Fading fiscal and monetary policy stimulus benefits.
The economic benefits from government stimulus checks Americans
received will fade if not repeated as will the benefits of augmented
unemployment insurance benefits if they are not extended after their
scheduled July expiration. The passage of additional measures to support
consumer finances is a wild card given the November elections. We are
already hearing reports that members of Congress are questioning whether
additional stimulus is needed given the early signs of an economic
rebound while other members of Congress voice concerns that the
increased unemployment insurance benefit is holding back employment
growth. There is also the question of whether Congress will provide
support to state and local governments to forestall likely layoffs
resulting from budget deficits.
While Federal Reserve monetary stimulus got credit markets
functioning supporting both the economy and asset valuations (albeit
artificially), its ability to stimulate future economic growth is
uncertain. Just how much more impact can the Federal Reserve have on the
economy when the 10-year Treasury rate is already below 1%? I guess
they could push rates negative and even buy equities to maintain the
“wealth effect”. If it came to that, it would be a sign economic growth
had weakened severely.
Factor 5. Economic impact of surging FAACT state infection rates.
The FAACT states contain nearly 1/3 of the U.S. population
They represent $6.8 trillion in GDP, nearly 1/3 of U.S. G.D.P
If businesses in these states are forced to again close their doors
or even curtail their operations, investors’ dreams of a “V” shaped
recovery could end abruptly.
Businesses are already closing their doors shortly after reopening
with Apple announcing it will close some stores it had reopened while
some restaurants including those in Texas are closing after reopening.
Source: USA Facts
Factor 6. Increasing business failures
While government programs for businesses have forestalled business
failures, not all businesses will be saved. Additionally, an increase in
businesses suspending operations in response to surging infection rates
would place additional businesses at risk of failing. Failing
businesses unable to repay their loans reduces the lending capacity of
financial institutions exacerbating the economic drag caused by failing
Factor 7. Mortgage forbearance can’t last forever.
At some point lenders will need to either a. Be paid or b.
Acknowledge they won’t be paid. Without a sharp increase in employment
and borrowers’ ability to resume loan payments, lenders will need to
reduce the value of their loans reducing their capacity to lend
constraining economic growth.
Factor 8. Natural disasters are not good analogies to use as
basis for forecasting the possible economic recovery from the damage
done by COVID-19.
Some economists have sought reassurance in equating this pandemic
with a natural disaster. However, this pandemic is different from a
natural disaster in two crucial aspects:
1. While a natural disaster is typically isolated to one area of one country, this pandemic is
2. While rebuilding often begins soon after a natural disaster with great force, current
economic rebuilding efforts are both tepid and vulnerable to significant setbacks.
Factor 9. End of year vaccine caveats
The hoped for and repeated reporting of a possible vaccine by the end
of the year often leaves off a key detail: The method being used to try
and develop a vaccine by the end of the year has never resulted in a
licensed vaccine during thirty-years of trying. Stories also may not
discuss the time it will take to manufacture the vaccine; let alone the
time it will take to get everyone vaccinated.
How likely is an economic fizzle? The table below compares the February and June Wall Street Journal
consensus forecast of economists representing the collective economic
outlook of over 70 economists. The outlook reflects more of an economic
fizzle than a sustained economic frenzy.
The economists on average expect 2020 to end with nearly 7 million
fewer jobs than the beginning of the year, an unemployment rate of 7% in
2021, and GDP not returning to 2019 levels until 2022.
Source: Wall Street Journal survey of economists
Stage 4: Fall
Yet, judging by the historic rebound in stock prices we saw
previously, investors seem to be ignoring this outlook. Instead,
investors seem be holding on to the hope for a “V” shaped recovery and
maintain hope that “This time is different” because this is more like a
natural disaster with fleeting effects, all while falling back on tropes
such as, “Don’t fight the fed” to justify today’s equity market
valuations in the face of tepid economic outlooks.
While hope-based valuations can be maintained for some time, hope is
not a firm foundation for valuations. This is especially true when
adding in highly unstable Investor sentiment. How unstable is investor
sentiment? Equity prices declined nearly 7% on June 11th alone, and that was during the frenzy stage.
At some point, if the hoped-for economic frenzy does turn into the
fizzle I envision, equity valuations will eventually decline to match
the reality of a slower economic recovery.
Now we wait and see what actually happens benefiting from a more complete view of the risks involved as we wait.
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