I received a newsletter this morning from a self-proclaimed contrarian value investment firm. The gist of the piece was that the US economy was experiencing a “V” recovery and that was going to be accelerated by the next fiscal and monetary intervention. The conclusion reached by these folks was that the next “stimulus” would “propel equity markets to sharply higher highs.” Again, this is a contrarian value investor! Their entire thesis hardly fits the confines of a traditional value shop. This is the same reasoning as the FOMO, BTFD, and Don’t fight the Fed types. Apparently, all approaches get you to the same place. The asymmetry of risk aversion is a behavioral reaction due to massive monetary insertions that have made market clearing impossible. Many market participants of the last decade seem to believe that downturns are so short lived that they no longer need to even consider them when allocating resources. So simply buy equities no matter what the backdrop and no matter what the path taken to this point might be. Golly, it’s gotten way too easy to manage exposures and risk. But what if it hasn’t? What’s next after the CARES Act insanity runs its course? According to our contrarian friends, more free stuff is coming our way so systematic risk has been removed from the investment decision process. We would like to present a few concerns that are largely being ignored by market participants. Each will have a negative economic impact starting in August and certainly through the balance of the year and beyond.
The End of Disincentives
The $600 extra hand out to those claiming unemployment will run its course at the end of this month. The big question then is whether there will be jobs waiting for these people. Hopefully, any fiscal insertion will contain contingencies to incent people to get back to work. Under this assumption we think it will be a mixed bag going forward. It is extremely likely that many jobs will be permanently gone, and that the new equilibrium unemployment rate will be meaningfully higher than it was prior to the pandemic. In our opinion this is unavoidable, and no fiscal package can avoid it. It will take a long time for these displaced people to find gainful employment and in the meantime this will result in slower economic growth.
As evictions spike over the coming months landlords will become public enemy number one. Just wait. Like everything in today’s culture, the AOC Sandinistas will make every effort to vilify and condemn them for trying to earn a living. So, either the landlords will suffer more hardships than they should have to in a country with personal property rights, or the evicted will experience homelessness at levels not seen since the Great Depression. Either outcome is undesirable as they are inevitable. The eviction process, like the bankruptcy process, takes time to develop and it seems many in our media and capital markets are simply looking the other way. Commercial and residential real estate investments are going to experience material changes in the coming quarters. Fiscal policy merely postpones reality it can’t eliminate it.
Bankruptcy takes several quarters to be realized. The pandemic will irrefutably produce the largest number of bankruptcies and defaults that our country has ever experienced. Despite the efforts of the PPP and the EID programs large swaths of small businesses will disappear. Too many of these businesses were operating at razor thin margins or even at a loss prior to the pandemic. Many took out PPP/EID loans only to default on them when the time comes. We have written about this in previous commentary. They are rightfully disgusted that the government mandated their destruction. For those that try to hang on as long as they can, the severe government imposed operational constraints will ultimately dictate insolvency. As these entities unwind in the coming quarters the economic impact will be material. As with the eviction process above, many market participants seem to be completely ignoring this inevitability. Eventually, valuations will be impacted.
The Federal Reserve Balance Sheet
Bernanke and then Yellen bloated the Feds balance sheet beyond any historical reference point. Powell has decided to take that to an entirely new level. Printing money (a liability) to insert liquidity into the capital markets has become the policy choice for the Fed. They buy securities (assets) throughout the capital markets using newly minted money (see the graph below). They have increased the size of the balance sheet by about 75% over the past few months. It is likely to increase to 100 to 125% over the coming months. Eventually, they will double the size of their balance sheet in less than a year – and this doubling was from an already bloated starting point. It is obscene what the Federal Reserve is doing. I realize we have written about this ad nauseum, but we just can’t help it given how the Fed has so perverted behavior and valuations. They literally are the primary reason why the markets have so decoupled from economic reality and that the fixed income markets have been virtually destroyed. When contrarian value investors use monetary policy as the only reason to be bullish, we’ve entered a new paradigm. How the Fed manages the balance sheet going forward will be an issue overhanging the markets for decades.
Tesla, an entity that wouldn’t exist without huge government subsidies, is now being valued more than all other car companies in the world (see the graph below) . This is simply ridiculous. This market is beginning to invite more Enron type madness. It is remarkably and eerily like the turn of the century when fundamentals were declared unnecessary. Too few stocks are driving this market. The performance gap between equal weighted and their sister cap weighted indices are at historical highs. Be patient.
How can an equity market (Nasdaq) hit new highs with the macro economy being what it is? A little common sense is in order. At the beginning of the year we had record low unemployment and sustainable supposed organic economic growth. Now, we have fiscal and monetary injections creating purely synthetic valuations, no organic growth, and unemployment not seen for decades. Somehow, this is good news for technology stocks? It defies logic, basic present value analysis, and equity valuation principles. If you are tearing your hair out trying to understand valuations you are not alone!
Federal Debt Levels
With each fiscal “stimulus” package we add to the federal debt. The debt level is now at approximately 125% of GDP, an historical all time high greater than even the short-term levels that resulted from financing World War II (see the graph below) . This will increase toward 150% as tax revenues decrease and more fiscal profligacy continues. If the Democrats sweep the election, we will undoubtedly approach Japan like leverage ratios. If the findings of Rogoff and Reinhart have any validity, then we can expect extraordinary low growth or far worse. Moreover, as local decision makers prevent kids from going back to school due to the pandemic, we will eventually have a generation that are maladjusted and even more angry; making them responsible for an irreversible debt load will negatively impact how they are able to live their lives even further. Thank you government. Like the Fed balance sheet, this will be a generational issue.
The Vaccine Option
It seems that the only other option that the markets are clearly betting on is that of a new vaccine to end the pandemic and completely erase all memories of it. Every news item that touts a successful trial adds a few percentage points to the equity markets. Interestingly, when it is proved that the vaccine is ultimately ineffective the market doesn’t lose any value. It’s a ratchet option. It is the fervor of this market. Stairway up will ultimately lead to an elevator down in our opinion. A vaccine is minimally several quarters away and will not be the global panacea the markets are betting on. Flu vaccines never are; from personal experience the worst flus I ever had were the years I had gotten a vaccine! We need to temper our expectations. Adding to the questionable effectiveness is the manufacturing and distributional logistics. It is a difficult road. Until then, the increasingly draconian measures being taken will further dampen economic growth. Volatility will increase as well.
Patience and Liquidity
We preach liquidity, patience, and conservative exposures. Investment opportunities will present themselves in due course. Managing risk smartly will be the most important part of the investment process. Currently, it is a tertiary consideration for inexperienced market participants. Too few of us have been around long enough to recognize market decoupling’s when we see them. Like 2000 and 2008 we realize that we may fall short in the very near term as the market squeezes returns out, but our job is to accumulate wealth optimally over the long term. Insert a presidential election into this dynamic and we are in for a lot of volatility over the coming months. Those that state “this time is different” will have to learn the lesson the hard way. Our clients won’t.