An overview of the current situation--- July 2020

On February 24, 2020, the S&P 500 hit a new high at 3380. Once the Corona virus hit, on March 20, 2020, the S&P shed a third of its value to 2304. On March 23, Jerome Powell and the Fed announced to respond to the situation through stimulus— a stimulus greater than the Federal Reserve’s response to the last financial crisis a decade ago.

By July 16, 2020, the S&P reached 3215, close to its former high in February. The 33% decline from the record high to the crisis low took less than five weeks, and the 44% recovery to the June 8 high— took only 11 weeks.

The stock market, along with credit markets began a rally and fluctuations which shows irrational exuberance.

The most frequent questions asked are, “why isn’t the stock market reflecting economic reality and the crisis?” After all, with riots across the world, and the virus; and with retail, hotel, and tourism industries hit so badly, how is the rally still possible?

Pershing Capital’s Bill Ackman has responded along the lines of— the S&P 500 consists of technology and other sectors which were more resistant to the pandemic because they had strong balance sheets and business models. The weighted average pulled up the entire market, where as hotels and retail got hammered but made up a smaller part of the index. 

I am more pessimistic and I don’t believe Bill Ackman’s thesis. I side with Jim Chanos his bearish thesis— companies such as Zoom, pharmaceuticals, are getting ridiculous multiples and will eventually have to come back to earth from its crazy orbit. I don’t believe in this crazy rebound during a pandemic which has brought the worst economic contraction in the last few decades. I just don’t know when reality will kick in, and I truly believe no one knows exactly when.

Investor should ask:

How much money is there? And where is it going?

So how much money is there?   Too much to ignore.

Federal Reserve Chairman Jerome Powell promised to “provide as much relief stability as we can.” In June, the Fed has dropped interest rates to zero, begun buying Treasuries and mortgage debt, and started an array of lending programs. When the Fed buys securities, it puts money into the hands of the sellers, and that money has to be reinvested. The reinvestment process, in turn, drives up the prices of assets while driving down interest rates and prospective returns.

The Fed’s buying is not based on value, high prospective returns, strong creditworthiness to protect it from possible defaults, or adequate risk premiums— its goal is to keep the markets liquid and capital flowing freely to companies. The Fed said it would provide an additional 2.3 trillion in loans, including those for mid-sized companies and aid to states and cities. 

What’s scary is a lot of companies are being saved discretely under a “repurchase” or REPO market. This is private so it won’t trigger any panic among the public, and it can bring liquidity not only to domestic companies, but international ones also. Central Banks and the Federal Reserve are concerned with saving the economy, even if it means prices that overstate financial reality. All told, the Federal Reserve is now near 750 billion, supported by 75 billion from taxpayers, to help large companies survive the pandemic—all part of its 2.3 trillion rescue package.

It’s hard to deny the correlation between Fed liquidity, interest rates, and stock prices.

Where is the money going?

Money has rushed into CDs, savings, checking, money market and other cash equivalents at a record pace.

How do we know? The M2 money supply, which tracks money in CDs, savings, checking, money market, etc., has never before spiked that quickly and that high (see below).

 

Investors pulled money out of stocks and put it into cash or cash equivalents. In times past, this kind of behavior was usually seen at major bottoms (with the exception of 1982 and 2001).

Who is swimming naked in a rising tide?

The Federal Reserve is actively pumping lots of money into the system, and there’s plenty of cash on the sidelines. Many bright minds claim that trillions in stimulus is not enough to restart the post-corona virus economy, and they may be right. But there’s a difference between the stock market and the economy.

As the experiment with quantitative easing in 2008 and thereafter showed, the Fed is content to just inflate the stock market and wait for the economy to catch up many years later.

The stock market’s initial response to Federal Reserve liquidity is not surprising. A retest of the March panic low is still possible, but stock market returns for the remainder of 2020 and 2021 are likely to exceed expectations.

Indeed, securities prices could rise further from today’s lofty levels, making the decision to hold cash even more painful, but I am not going to go astray from the fundamentals of buying at reasonable prices. Easy borrowing, and capitalism without the consequences is like believing in the after-life without hell.

In a time of exuberance, many companies get listed, and a lot of fraud gets unnoticed (if you read the papers, look at the Wire Card situation in Germany and the Chinese Coffee company Lucking Coffee). In bad times, companies get sober and they fix things up.

The higher the market goes, the more people believed that Central Banks and the Fed can keep propping the market up.  Everyone is convinced that interest rates will be lower for longer— Fed Chairman, Jerome Powell announce on June that there will be no rate increases through 2021.

Interest rates, or the cost of borrowing, are like gravity. The lower the rate, the lower the discount rate used by investors, since the U.S treasury bonds is the safest investment for the given risk, and thus is called the risk free rate—it is a risk alternative investment when weighed upon other investment opportunities. Without such as safe haven, investors are forced to invest elsewhere. With lower and declining rates, present value of future cash flows are higher, and asset values get inflated.

Therefore if the Federal Reserve buys debt that has just been downgraded to junk, it is likely to lift the price of those bonds, and the price of other non-investment grade debt is likely to follow. Lower yields on bonds, means that investors naturally shift to stocks. People just don’t want to miss out.

Even before the pandemic, blue chip companies have been big borrowers, and few companies have been able to resist the lure of leverage. 

“Not only is the volume of debt high,” said Fed Chairman Jerome Powell last May, “but recent growth has also been concentrated in the riskier forms of debt. . . . Among investment-grade bonds, a near-record fraction is at the lowest rating—a phenomenon known as the ‘triple-B cliff.’ ”

Powell was referring to the fact that a large number of companies’ bonds were dangerously close to junk status. “Investors, financial institutions and regulators need to focus on this risk today, while times are good.” 

Powell has stopped preaching. Facing the frightening prospect of widespread corporate insolvencies, the Fed on March 23 announced a credit facility designed to support the corporate bond market. Two weeks later, the central bank stunned Wall Street by saying it would go into the open market to buy some junk bonds as well as shares in high-yield bond ETFs. 

In the last two months alone no fewer than 392 companies have issued $617 billion in bonds and notes, piling on still more debt that they may not be able to pay back.

  

Below is a chart from the Forbes article.

According to a Forbes investigation, which analyzed 455 companies in the S&P 500 Index—excluding banks and cash-rich tech giants like Apple, Amazon, Google and Microsoft—on average, businesses in the index nearly tripled their net debt over the past decade, adding some 2.5 trillion in leverage to their balance sheets.

The analysis shows that for every dollar of revenue growth over the past decade, the companies added almost a dollar of debt. Most S&P 500 firms entered the bull market with just 20 cents in net debt per dollar of annual revenue; today that figure has climbed to 38 cents. 

Once the coronavirus pandemic hit commerce worldwide, the tide was briefly gone, and we got to see who was swimming naked—revenues have evaporated, but their debt still remained. The Fed has created irresponsible money through easy financing, and bond issuance that are more than oversubscribed.

Irresponsible companies are able to refinance their debt and stay alive when they’re supposed to be dead, regardless of how bad their financial condition have been.

For example, Hertz used to be the darling of the rental car industry and way ahead of Avis. Carl Icahn, the corporate raider wanted to go in and shake things up, and since 2014, they’ve been on their 4^th CEO. Even Icahn in the end couldn’t stop the inevitable chapter 11, and additional equity raised in bankruptcy would just go to creditors and end up being scrap paper. Investors aren’t prudent and it shows you how much irrational behavior exists right now with retail investors and millennial Robinhood traders.

While many countries have had strict bans and shutdowns, many, such as Hong Kong and Japan, have experienced major relapses. Until there is a cure or vaccine, reopening the economy always triggers a relapse. Actual GDP declines are on the order of 20-35% and in most countries, unemployment has surged.

A bounce from the depressed levels of late March was warranted at some point, but it came surprisingly early and quickly went incredibly far. The S&P 500 closed last night at 3,113, down only 8% from an all-time high struck in trouble-free times.

As such, it seems to me that the potential for further gains from things turning out better than expected or valuations continuing to expand doesn’t fully compensate for the risk of decline from events disappointing or multiples contracting. I have skimmed over a lot of companies and I can’t find too many compelling ideas after the quick recovery of the financial markets from Corona virus.

The aggregate market cap of 5000 companies to U.S GDP is at an all-time high. Even higher than before the 2000 and 2008 crash.  Big declines may lie ahead for GDP and earnings.

The yield curve has inverted. Long term bonds, which are supposed to yield more due to the risk of increased time until maturity have yielded less than short term bonds. But while the U.S has not issued negative interest instruments, interest rates are ridiculously low even before the Corona virus.

I am no macro-economist. I am not sure how the market will play out. 

Everyone is trying to be intelligent. I’m just trying not to be stupid.