I'm generally inclined toward a bullish outlook. Throughout the previous bull market, I stayed upbeat at times, such as December 2018, when many people thought a new bear market was upon us. Even now, I remain optimistic for the next five years.
The economy was in structurally decent shape prior to the pandemic, and we didn't have the sorts of massive financial problems - such as the 2000s housing bubble - that typically lead to severe downturns. In short, I'm firmly in the "This is not a new great depression" camp, and I think the S&P 500 will make new all-time highs within the next few years.
That said, bulls really need to calm down a bit right now. The "V-shaped recovery" rhetoric is getting a bit out of hand. After a huge rebound since the March lows, we should expect the markets to chop around at a minimum, and we'll likely see another sizable decline. This certainly isn't the time to be chasing stocks to the upside. Here's why I'm cautious.
Sentiment Is About To Sour
While we've seen a huge round of optimism in financial markets, things over on Main Street look far less promising. Economic numbers are the worst they've been in decades, and they're still getting rapidly worse, at least for the time being. Not only are things not improving yet, we don't even know how deep the hole is at this point.
Investors are cheery now as the possibility of reopening the economy looms large. But once everything is reopened for a few months and we start seeing just how much economic activity disappeared, expect sentiment to turn sharply lower. The early data we're seeing out of China's reopening is not especially promising. And with unemployment at its highest since the 1930s in the U.S. and other developed countries, it's unlikely that economic activity will come roaring back here either. A consumer-spending driven economy will sputter when you lay off a massive chunk of the workforce, even disregarding any lingering effects of the virus.
If you watched Warren Buffett's monologue Saturday afternoon from the virtual Berkshire-Hathaway (BRK.A) (BRK.B) shareholder meeting, it only added to that feeling. While Buffett reiterated his bullish-on-America for the long-haul perspective, it was mixed with a rather dour assessment of the current crisis. You know you're in for a dose of tough talk when Buffett started off by saying that things aren't quite as bad as the Civil War. That's a rather low bar to clear in terms of ranking American societal and economic disasters. In any case, it's obvious that Buffett doesn't think this crisis is over by any stretch of the imagination simply because some businesses and states are starting to reopen.
Personally, I don't buy or sell stocks because of what famous investors say. That said, notable investors do have an impact on market psychology. Their outlook can become a self-fulfilling prophecy, at least in the short-run. Buffett hinted at that himself on Saturday, saying that he was refraining from discussing some potential scenarios because it would increase the possibility of them happening.
While Buffett may not have said the quiet part out loud, it's apparent that he and Berkshire have a mixed to negative view of the market here. That's clear from the dialogue on Saturday, it's clear from the Charlie Munger interview with the Wall Street Journal last month, and it's clear from Berkshire's portfolio actions this quarter.
Berkshire bought almost nothing during the March crash. Meanwhile, it unloaded billions in equities including a wholesale liquidation of their position in the airlines. Traders will put two and two together. If Buffett thinks the market wasn't a bargain in March let alone now, many people will sell based on that reasoning as well.
Commodities Are Plunging
Here are five-year charts of a bunch of major commodities. While a few are trending up, such as rice and palladium, the vast majority of them are heading downward. Many, in fact, are at or near 5-year lows now thanks to the pandemic:
Some are even worse than that. Corn, for example, is near 45-year lows. That's in nominal terms - not even adjusted for inflation. Similarly, coffee sold for a dollar per pound during the 1970s, it's back to near that level again now. The list of struggling commodities is long. If your thesis is that Fed balance sheet expansion is causing or about to cause a massive lift in the price of everything due to debasing the dollar, you need to explain why so many commodities are trading as if we're entering a massive global bust.
Simply put, it's hard to look at this and claim there is any indication of near-term inflation coming. These are the inputs that go into so much of the stuff we buy. If copper, lumber, cotton, and most food products are all at or near multi-year lows, how exactly are we going to get an inflationary wave?
That's even before you get to crude oil, which has been a complete fiasco as of late. Again, it's really hard to imagine some sort of stagflationary period or major drop in the value of the dollar when gasoline is selling as cheaply as it is.
I suspect the Fed's aggressive actions will eventually lead to higher asset prices - just as the Fed's strong reactions in 2001 and 2008 eventually led to big surges in housing and stock prices years later. But these feedback loops simply don't play out in a month. You have to get through the economic bust first before the expanded money supply really starts to affect the markets.
Bonds Are Signaling Deflation
Another issue with this rally is that bonds remain much too firm. The benchmark 10-year U.S. government bond soared in March as markets started to tank. Prices briefly dipped, but are now consolidating again right around all time high prices (and thus all-time low yields):
High bond prices indicate that the credit market is excepting deflationary pressures and weak economic performance. The fact that bonds haven't given back even a bit of gains over the past month as stocks soared is most troubling. When credit markets and equity markets disagree, the credit market is usually correct. And right now, bonds are acting extremely bearish.
It's not just treasuries either. Look at mortgages as well:
The coronavirus continues to have the U.S. economy in a stranglehold. But those looking to buy a home or refinance an existing mortgage got some good news Thursday. Mortgage rates hit a new all-time low.
The average interest rate for a 30-year-fixed rate mortgage hit 3.23%, with 0.7 points paid, for the week ending April 30, according to Freddie Mac. That’s down 0.10 percentage points from 3.33% last week and a hair below the previous all-time low of 3.29% set earlier this year in March.
This simply doesn't fit - at all - with the Fed printing us back to prosperity idea, at least in the short-run. The stock market is pricing itself as if we're about to see a return to record earnings and dividends soon, yet other assets like bonds, mortgages, and commodities are saying that we have another leg coming down.
These other financial markets imply that the March panic was the first acute phase of a broader downturn, rather than a discrete event. Does this mean the S&P 500 necessarily breaks the March low? No. But it does mean that investors should hold their horses on the V-bottom and then race back to the highs theory.
It'd be strange to get more new highs in stocks while bonds and commodities are both preaching deflation. The idea powering the stock market rebound is that the Fed's asset purchases and the government's fiscal stimulus are enough to be a bridge for the economy until actual activity picks back up and earnings growth resumes. But bonds and commodities are having none of it.
World Impact: This Is A Global Crisis
There's also the matter that this is a global recession (or worse) happening all at the same time. Generally downturns hit some regions more quickly and more sharply than others. Some countries/regions such as Canada, Australia, and Latin America largely avoided the 2008 Financial Crisis. Others, like Europe, didn't see their banking systems bottom out until a few years later, whereas the U.S. was already well into recovery by 2011-12. In this way, the global economy held up better because you didn't have acute problems hit everywhere all at once. By contrast, if everyone's banks had a simultaneous liquidity run in October 2008, the crisis would have been far worse.
While the 2020 recession doesn't have the same depth of structural issues in it that we had in 2008, we now face the challenge that everyone's economy is freezing over at the same time. There's no region that is doing better and can take advantage of weakness elsewhere by buying up cheap assets/products. Normally, in a bust, for example, you'd have people from other regions flooding in to take vacations, buy houses, and purchase things at attractive prices and exchange rates. With global travel shutdown, this sort of automatic stabilizer within the capitalist system is currently out-of-order.
Additionally, the abject collapse of global commodity markets will cause all sorts of second-order shocks over the next year or two as well. From Russia and Saudi Arabia through to Nigeria, Colombia and beyond, $20 oil threatens to decimate government budgets and cause societal unrest. Who knows what impact that, in turn, will have on financial markets and earnings for multinational firms. A coordinated emerging markets bust, as we saw in 1997-8, is enough to roil markets even in good times. Now throw a bunch of defaults and economic collapses in periphery economies into a mix where developed countries are already facing 15% unemployment and things get downright messy.
The Takeaway: Another Stock Market Drop Is Coming
None of this is insurmountable and it's unlikely that we're heading into another depression. I was bullish and buying stocks closer to the March lows. The capitalist economic system is pretty resilient. Throw in unprecedented Central Bank activity to try to juice markets, and things will come back sooner or later. The permabears currently predicting the second great depression are unlikely to be correct.
But at these prices, the market is barely down year-over-year, and many leading growth companies are actually up over the past 12 months. That's simply incredible given the economic mess that has developed since then. Part of investing is discounting risk. At present, the U.S. market has priced in close to no additional risk since last year.
I generally side with the crowd that says we'll bounce back relatively quickly from the coronavirus. Still, S&P earnings and dividends probably won't be back to where they were pre-crisis until, let's say, 2023. And there's the possibility of a significantly deeper drop than that if there's a second wave of the virus and/or more uncontrolled economic chain reactions that go off from the damage caused by social distancing.
The S&P was valued at 3,000 last year with a healthy growing economy, a trade deal with China, and no pandemic. How is 2,850 - a mere 5% drop - the right price now? Consider the massive declines in earnings and dividends, soured relationship with China, a bombed-out commodities market, huge unemployment both in the U.S. and everywhere else, and the specter of rolling waves of popular revolt around the world in countries that don't bounce back from this economic blow anytime soon.
The Fed providing seemingly infinite liquidity is a good justification to buy assets at a steep discount when stocks are in freefall. I don't dispute that. In fact I was making that argument myself in March with the S&P under 2,500.
But will the Fed feel compelled to keep pulling out all the stops now that markets are stabilized and things have calmed down? Similarly, don't expect Congress to line up more aid for struggling Americans if the stock market is booming again. Already, Senate leader Mitch McConnell has signaled opposition to more big spending packages thanks to concern about the national debt. As we saw with the first failed TARP vote in 2008, if you want to pass a major aid package, you need to have stocks plunging to create a sense of urgency. S&P 2,850 isn't going to get the job done.
While anything is possible, it'd be highly unusual to have an entire bear market play out in the span of one quarter. The only modern bear to end nearly this quickly, 1987, was a technical phenomenon that was not driven by significant underlying economic weakness. When that's the only precedent you have for a potential V-shaped recovery now, you should be cautious.
Particularly with the economic data still getting profoundly worse, there won't be many signs of "green shoots" in the overall data until this fall or later. There's no rush to chase stocks here up a quick 30% off the lows. Patient investors will be rewarded with better prices.
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