Use The Biggest Sucker's Rally In History To Kill Your Zombies

Summary

• The rest of this year will be cleaning up a mess that is much stickier than investors give it credit for.
• Valuations are still high across most of the S&P 500, and plenty of zombies will never see their share prices never recover.
• Kill your zombies.
• This idea was discussed in more depth with members of my private investing community, Margin of Safety Investing. Get started today »

The stock market rally since March 24th has been built on the notion that naked bull market analysts can call a bottom and that the Federal Reserve can bail out everything. I can assure you that neither idea is true and that one is less true than the other.

The amount of bullish analysis that I am seeing across the financial media from CNBC to Seeking Alpha and everything in between is astounding to me. The lessons of this year's crash have not been learned.

This bear market rally reminds me of the "buy it now" ideas I heard in the autumn of 2008. The lessons of the financial crisis have been forgotten or never made the reading list of newer investors.

You have a chance to sell a lot of bad assets right now at prices that are more than fair. You should expect that, while the Fed can create zombies, it cannot create growth. Eventually, the zombies will starve. Kill your zombies now.

A Look Back At Autumn 2008

In the 4th quarter of 2008, after TARP, stock market bulls, the same ones who for over a year didn't see the crash coming, even after Bear Stearns told people to buy stocks. Then, the first quarter of 2009 came, and stocks fell another 30%.

I am not suggesting that the bottom isn't in for this bear market. I am saying that the top of this phase of bear market rally might be. I am also suggesting that a retest of the bottom is very likely.

On the retest of the March 23rd trough, the stock market could stop short or crash through it. We don't know yet. What we should, even at an instinctual level, know is that the economy is not out of the woods, so therefore, the stock market is not either.

The Biggest Sucker's Rally In History

The recent rally has been the sharpest and fastest in history. It is filled with "Hopium" that the world will magically recover from disease and economic destruction.

The rally on the SPDR S&P 500 ETF (SPY) and Vanguard S&P 500 (VOO) from trough to last night's (April 14, 2020) peak was 27%. That is a monumental rally for the record books. The Hopium-based FOMO chase is mind-boggling.

The rally is not backed by valuations or the economy.

Stocks are still a second standard deviation risk.

The newest projections for unemployment are to exceed 20%. Consider that many of these people will be unemployed for over a year.

Trade and GDP growth have been tied at the hip for centuries. While machine learning was going to move supply chains over time, the impact of the trade war short term was clearly negative. The cyclical impact of the trade wars has been felt for some time now, and coronavirus is another massive hit.

Source: tradingeconomics.com

Manufacturing was already suffering before coronavirus. It's worse now.

The U.S. economy is about two-thirds consumer-driven. Most of that is shut down right now. Most of the rest of the economy is open to some degree. So, we are looking at about 60% of the economy turned off.

The economy is $21 trillion. That means each week normally represents about $400 billion of GDP. Each week, we remain "closed", the economy loses about a quarter trillion of a full year's GDP.

If the economy stays largely shut until the end of May, then we can expect GDP to contract about $2.5 trillion over the ten weeks of shutdown or 11% on the year. That is about where Goldman Sachs (GS) is estimating for lost GDP. It will likely be a bit more with presumed phased reopening. Let's ballpark the loss of GDP around 12-15% for 2020 versus 2019. For comparison, the peak to trough decline in GDP during the Great Recession was 4%.

The lost earnings for corporations cannot be overstated. Also, there should be no expectation that GDP rebounds to 2019 levels until at least 2022. I discussed that more in my Quarterly Outlook & Game Plan available to members of Margin of Safety Investing.

The Federal Reserve Can't Bail Enough

The main narrative out there is that the Fed is going to make it alright like a warm blanket. Let me splash some cold water on that notion. The Federal Reserve does not really have "infinite money" as some would like to suggest.

Ultimately, the Fed is limited by the value of the currency. And while I am not a dollar bear by any stretch of the negative commentators' imagination, I am also not blind to the perpetual relativism regarding currency strength.

When all is said and done, and surely, another round of relief and stimulus occurs this year, the Federal Reserve will have a balance sheet approaching $10 trillion. That is 10x what it was 15 years ago. And, it is going to be roughly 40% of our federal debt. The United States, in essence, is going from about $24 trillion of debt to $35 trillion of debt in one year. These are dangerous levels that will come with repercussions.

The main repercussion I see for companies is tighter credit for years. Credit will be especially tight for companies that do not have strong organic growth outlooks.

Stock Repercussions

Companies that are capital-intensive or rely almost exclusively on the broad growth of the economy are going to see problems in the 2020s. While I see several booms within the 4th Industrial Revolution and shift to the "smart everything" and alternative energy world, many companies will not participate.

Companies with highly leveraged balance sheets are likely to see the can-kicking era come to an end, as interest rates will begin to rise sooner than people believe now.

The shale space comes to mind as a dying industry. I talked about those companies and their plight here:

Shale Oil's Final Theft From Shareholders

Burying Oil With No Resurrection In Sight

Certain office REITs seem to be questionable investments at this point as the "work from home" economy is also taking off of necessity. The reality is that shift was coming over the next decade. Now, it's suddenly here. Investors should expect dividend cuts as vacancies rise and rents fall.

Mall REITs have a massive transition to make, and it will be very expensive. I do not know how malls survive both Amazon (AMZN) and social distancing. Investors should expect dividend cuts as vacancies rise and rents fall. I see a few bankruptcies coming.

My research shows that over 100 dividend-paying companies in the S&P 500 are at risk of having to cut their dividends. What does that portend for their stock prices? If their market caps fall below $10 billion, their stocks can be removed from the S&P 500. That would create another wave of selling. I strongly recommend selling any highly leveraged dividend-paying S&P 500 stocks that cannot pay dividends out of free cash flow. I will regularly feature at-risk stocks in coming months.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.