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 markets.

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 claims.

Consumer Frenzy

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

Economic Frenzy

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.

Stimulus Frenzy

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.

Vaccine Frenzy

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.

Media Frenzy

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: Fizzleto 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.

Factor 3. Despite substantial government financial support, consumer finances remain weak.

The number of renters paying with credit cards in May was up 58% from February. Millions of Americans remain unemployed and/or with reduced hours.

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 businesses.

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

occurring globally.

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.