The Great Disconnect: Stocks Vs. Real Life

Summary

• Deep recession. Depression. Whatever people wish to call it, yes… it's that dreadful.
• U.S. stocks in the total market Wilshire 5000 Index are roughly halfway between their March lows and record highs from February.
• The financial system’s issues alone should be enough for investors to recalibrate their economic expectations.
• A significant percentage of the economy is relying on the Federal Reserve to “get by” to make payroll and pay interest on debt obligations.
• Eventually, the stock market responds to an accumulation of bankruptcies.

Leading into 2020, the economy was growing at a modest pace (1.9%). By the end of the second quarter, the economy will have recoiled at its quickest clip (-25%+) since the 1930s.

Similarly, at the start of the year, unemployment for working-aged individuals was 3.5%. By the end of Q2, the official unemployment rate may spike as high as 20%.

The economic facts are as disheartening as they are sobering. For example:

(1) Consumer confidence plummeted to a 47-year low.
(2) U.S. retail sales dropped by the most ever in March.
(3) Small business confidence dropped to a record low in April.
(4) 84% of small firms will pay less than half their rent in May; 40% will skip rent altogether.
(5) State budgets will rack up $100 billion in deficits in 2020.

Deep recession. Depression. Whatever people wish to call it, yes, it's that dreadful.

On the other hand, it has not been quite as bad for financial markets. U.S. stocks in the total market Wilshire 5000 Index are roughly halfway between their March lows and record highs from February.

Without question, there's a disconnect between U.S. stocks and the real economy.

Granted, there are those who optimistically tout the imminent reopening of states and businesses across the country. Yet, is it really the case that the post-virus economic environment will snap back quickly? Or is it far more likely that significant damage has been done to global supply chains and domestic demand across a wide range of industries (e.g., energy, transportation, manufacturing, hospitality/tourism, auto, sports/leisure, restaurants, basic materials, lending/insurance/financials, commercial real estate, brick-n-mortar retail, consumer discretionary, etc.).

The financial system’s troubles alone should be enough for investors to recalibrate their economic expectations. The dramatic underperformance of the SPDR Financial Select Sector SPDR (XLF) relative to the S&P 500 SPDR Trust (SPY) here in 2020 bears a strong resemblance to the fallout in 2008.

In particular, lenders and banks are tightening the reins. Not only are they hoarding more cash to deal with boatloads of toxic debts, but they’re less willing to extend credit.

Not just to riskier businesses or families with borderline credit scores. Even wealthier folks are running into trouble securing jumbo mortgage loans.

It should go without saying that a whole lot of those aforementioned economic segments - energy, transportation, manufacturing, hospitality/tourism, auto, sports/leisure, restaurants, basic materials, lending/insurance/financials, commercial real estate, brick-n-mortar retail, consumer discretionary - can only “get by” for a short while to make payroll and pay interest on debt obligations. That’s what the Fed’s programs are capable of achieving.

What’s more, in a world where central banks can toss trillions of dollars into the financial ring, the massive amount of monetary stimulus can backstop risk assets from investment grade bonds to “junk” debt to stock prices themselves. (Or at least the activity can stop prices from falling into an abyss.)

What the Fed cannot do, however? The Fed cannot create customers out of thin air.

If pandemic-induced hardship adversely affects longer-term demand for goods and services, corporations generate less and less revenue. With less revenue, there's less money to pay back obligations (bonds), offer dividends and/or engage in share buybacks (stocks).

The dividends cuts/suspensions have barely even started, and…

… the decline in buybacks may be wildly underestimated.

Again, the Fed can pump dollars into the system where market participants can choose to speculate on the “work-remotely” economy. Certainly, Jim Cramer will direct you to the hashtag winners in “work-from-home” technology, life sciences, e-commerce and mega-caps like Facebook (FB), Apple (AAPL), Amazon (AMZN) and Microsoft (MSFT).

Still, when investors pile into a tiny portion of the overall stock pie, the valuations of these companies eventually decouple from common sense. Investors rethink their premises. And the wildly-overvalued leaders head down to meet their less vibrant cohorts.

Those who see Fed intervention as doing enough are not cognizant of the credit cycle realities. When people/businesses cannot get enough credit, when the skyrocketing unemployment rate adversely impacts demand for goods and services, when corporations simply cannot generate enough cash flow to cover their liabilities, they seek bankruptcy protection. Sooner or later, the stock market responds to the accumulation of bankruptcies.

I’ve said it before and I will say it again. This bear won’t end until the Fed is buying stock ETFs. Yet they won’t be buying stock ETFs to directly hold up equity markets until a second collapse in faith occurs. Right now, stocks are sufficiently off their March 23 lows to keep the Fed from firing the ultimate bazooka.

In the meantime, many of our moderate growth and income clients continue to benefit from our tactical shift in February. For the time being, rather than a 60-65 stock target/30-35 income target, our allocation remains protective.

The 33% equity component may be split between large-cap domestic ETFs and select individual securities. In the ETF space, we have been favoring Vanguard Mega Cap (MGC), iShares S&P 100 (OEF) and/or Vanguard S&P 500 (VOO). Our individual securities include the stock shares of select companies such as PepsiCo (PEP), Adobe (ADBE), AbbVie (ABBV), Fortinet (FTNT), Wheaton Precious Metals (WPM), Johnson & Johnson (JNJ) and Crown Castle (CCI).

The 33% income component has been largely assigned to Treasuries and shorter term investment grade like Vanguard Short-Term Corporate (VCSH). We also incorporate muni bonds in taxable accounts, Invesco DB USD Bullish (UUP) and a number of digital storage REIT preferreds from Digital Realty Trust (DLR) and QTS Realty Trust (QTS).

The rest is in cash. My Registered Investment Adviser may not be Warren Buffett’s Berkshire Hathaway, but we certainly appreciate the “optionality” of cash.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Comments

[ijeff]

I'm starting to think there's another even great disconnect today. Real life today verses real life as it once was.

[Bhughes7918]

OPY would make it thru lots of cash!
Oppenheimer Holdings Inc. Announces Share Repurchase Program

CNW Group•May 15, 2020

NEW YORK , May 15, 2020 /CNW/ - Oppenheimer Holdings Inc. (OPY) today announced that its Board of Directors approved a share repurchase program that authorizes the Company to purchase up to 530,000 shares of the Company's Class A non-voting common stock, representing approximately 4.2% of its 12,636,523 currently issued and outstanding shares of Class A non-voting common stock. This authorization will supplement the 98,625 shares that remain authorized and available under the Company's previous share repurchase program covering up to 640,000 shares of the Company's Class A non-voting common stock, which was announced on July 26, 2019 , for a total of 628,625 shares authorized and available for repurchase. The share repurchase program is expected to continue indefinitely.

[capcondo]

Major bear markets going back to 1929 have behaved in a very similar way. These markets are 1929-1932, 1973-1974, 2000-2002, and 2007-2009. They last 2 to 2 and 1/2 years. They drop 50% or more from the high. There is a strong initial drop and then a recovery in the 1st year of the bear market. Overall, they do not drop much in the first year of the bear market. They drop far more percentage wise after the first year of the bear market. I think this is the buy the dip syndrome in the first year of the bear market.

I think we're in one of these bear markets now. The only difference this time is the total influence of the FED (which may do something to the timing of the bear market). But, so far, this market has performed very much like the bear markets cited above.

In 1921, the market was at it's lowest level ever recorded on the Shiller Index 2.5 years after the last pandemic. Food for thought.

[DividendInvestor2018]

This is an insightful analysis.

[StkAnalystGuru]

You are right Gary, the market is way too high, but the Fed is injecting so much capital and the hope for Remdesivir kicked the Fibonacci pattern up an extra level, keeping the bull alive longer than it should have been! The 50 DMA normally would have been resistance, but this is ridiculous. My work indicates strongly that MONDAY will be the high, so be prepared for a big GAP DOWN on Tuesday... You all are welcome.

[User 1105879]

@StkAnalystGuru — I hope you’re right!

[StkAnalystGuru]

NOPE! THE FED is buying SOO many futures every night, you can SEE the exaggerated huge buying spikes at like 3am or 4am, shoving the SPX futures up over and over again, the game is rigged. It does NOT pay to short anything overnight. Buy only now until further notice.

[Austin Rogers]

Thanks, @Gary Gordon for an excellent overview of the present situation. Are you worried at all about the possibility of a wave of downgrades in BBB-rated corporate bonds? Last I looked, I believe VCSH held roughly half BBB-rated bonds. Intuitively, I would think that VCSH's managers would need to sell the fallen angel debt at a discount in order to get it out of their fund.

[Petrarch]

Gary,

I know its very, very hard to comprehend this
Its the same reason we are bad at dealing with exponential change.
We all find it hard to imagine anything outside a limited set of parameters

The market looks into the far future and extrapolates
Right now it sees low inflation, very low interest rates and a return to growth at some point
None of those may be true
But current or even past data are not really all that useful
That's why most pundits and prognosticators if not all, get it wrong, constantly.
This is not due to lack of intellectual horsepower, it is due a lack of imagination

Every investment is mostly about expectations
If you believe people won't travel or eat out, buy homes or get haircuts ever again then ok.
But the market right now thinks otherwise.
That's all.

P

[glinsight]

@Petrarch Yes "We all find it hard to imagine anything outside a limited set of parameters" and "the market right now thinks otherwise". But the market consists of all of us, so what's really driving the market?
IMO, the primary reason the market continues up has little to do with a recovery. It’s more about the Fed pumping cash into the economy, creating a FOMO-driven stock market.

[Redford2345]

In one 45 day period, this Country went from the best to a depression. I love our President but strongly disagree with his "V" shaped recovery vision. I think this damage is going to take at least 3 years to correct, if ever.

[woppenhe]

When and IF we get a vaccine, fine. But otherwise we will have to learn to live with the virus. This is not new for other generations, just for some of us. Polio, Whooping cough, Measles, AIDS, SARS, Spanish Flu, Plague, and others long forgotten altered the expectations and ways people went about their daily lives. This is different yes, with perhaps a 5% (greater in some reports) fatality rate for those contracting; people apparently will be left to their own devices and desires to avoid the germ, so it is now up to each of us to decide when and how we shop, travel, and recreate. Opening up means nothing to a virus. It will continue until it cannot find an immune vector. With perhaps a 2% penetrance to date, we have a long way to go. Markets will adjust right along with us. Avoiding obvious exchange areas, such as airports, sports venues, rock concerts, intimate restaurants could be one theme. Working from home (FANG, home improvement) could be another. Traveling by RV to avoid public mixing as much as possible could be another. And prevention and fortification / PPE / testing in schools, prisons, hospitals, factories, and nursing homes, yet another. Just think about the possibilities while observing human behavior as it plays out. Eventually it will fade into the background(vaccine or herd immunity) How much human damage in the meantime is up to us; we have established that we can control the rate, but at great economic cost. So we will have to learn to live with the virus. And the next one as well.

[Dale Roberts]

So funny, I was just looking at a bunch of PE and forward PE charts for US stocks.

The stock market makers think this global pandemic is the best thing to happen to company and economic prospects in decades.

I guess I'm just reading too much gloomy pandemic stuff. ;)

Dale

[User 1105879]

@Dale Roberts – It’s all Fairy tales and magical thinking. They just make @#$& up. The bond market and gold are calling BS on their BS.

[Valued Rug]

Just read this interesting piece by an investor in the U.K. who made millions off the back of the financial crisis and who sees a similar story playing out now:

www.opendemocracy.net/...

The gist is, QE money ends up in the hands of the rich, who tend to spend it on financial assets (even more so when restaurants, theatres and tourism is shit down). Thus markets go up.

Can the real economy ever halt this?

[1retiree]

If there is a wave of bankruptcies, there will be lots of assets for the healthy to pick up cheap.

[Sjmuk1]

Great article, thanks. Add in the likelihood of negative interest rates too if a further leg down breaches previous low. I’m Looking for negative interest rates, fed buying equities and a dollar reversal to suspect where the low may be found. None of those three have occurred yet. Second wave of Covid likely as soon as schools re open and kids start mingling together. IMHO

[kbaba]

With such a negative outlook, why no short positions or hedges? Should be easy money in such an inflated market with the virus not going away soon

[Proud Capitalist]

Fundamental facts wrong: "Leading into 2020, the economy was growing at a modest pace (1.9%). Why did you make that number up? Did you choose it because 1.9% sounds worse than 2.0%? The actual rate was 2.1% in the fourth quarter (www.bea.gov/...), and the growth for all of 2019 it was 2.3%. Is this bias? Hey, I know its 0.4%, BUT that's BILLIONS of dollars. How do you get this number wrong?

www.bea.gov/...

[StkAnalystGuru]

It's really IMMATERIAL, is it not? Whether GDP was 1.9% or 2.3%, it does not alter his point or change his message or thought process in ANY way. Try not to be so myopic and argumentative, or pompous, or caustic, perhaps? Just a thought. Cheers.

[Dale Roberts]

Thanks @Gary Gordon I am writing on same and can only come to many of the same conclusions. The stock markets can certainly disconnect from the economic realities, and they can be forward thinking. But there's nothing to see in the future it's very dark. But it's an obvious 'guess' that there will be no quick economic recovery. And hence the bankruptcies and other bad numbers pile up, and the markets eventually take notice.

There has never been a major stock market correction without a 'sucker rally'.

These do not look and feel like the conditions to set the table for the first major correction without a re-test of lows, and perhaps more.

We have to do the economic restart right, and only once. If we goof that up with second and third waves of outbreaks, pencil in that Depression

Dale

[thumb.ai]

If the voting machine popularity of the top 5-7 stocks turns into the weighing machine of valuation, while unemployment is still above 10%, I see another stock market correction.

However, if enough people get back to work quick enough, then the time of danger passes.

Bankruptcies only worry me for their impact on unemployment. Otherwise the dominant market cap weighted funds like S&P 500 will shrug them off.

[MkZSM]

I think right now the question is at what levels will market sell off to because I don’t think we will make lower lows in my opinion unless warren buffet see’s something we all fail to see.

[Redford2345]

I'll put my money on Carl Icahn vs Buffet any day of the week!

[Mollypik]

How many of you here just watched the rally on the sideline? There were so many dips since march and if you bought any of one of them, you made money. That's all it matters. Look at MSFT, TWLO, PYPL, ROKU, SHOP, FSLY and so many other tech names. If you own a few of these names and book insane amount of profit along the way, you would not be here complaining why stock doesn't go down.

[g18]

Don't really understand why people would prefer the market to go down. The economic suffering is bad enough. Looking for it to improve and the market to lead the way.

[jezwhitaker]

Because valuations in equities are based on the view that a company is worth investing in for its earnings. These stock prices do not justify the valuations.

[Mollypik]

So what? Buy the dip then trim some or close it with 40% plus gain and move on.

[Greg Gallagher]

@Gary Gordon The Nasdaq Index closed in positive territory today (up just +0.1% for the year); but this is a big "Divergence" from the other indexes and almost every other market indicator (or recent economic report). The S&P 500 comes in 2nd place at -10.8% YTD, Dow -16.3%, NYSE -20.1%, and last place Russell 2000 -23.1%. If you look at the stocks driving the Nasdaq's performance, it hasn't change much in the last 5 years, FAANG stocks account for the biggest share of the Nasdaq's gains: FB +2.93%, AMZN +28.1%, APPL +3.44%, NFLX +34.9%, and GOOGL +2.23%. Since the market doesn't like conflict ("Divergence"), either the Nasdaq must fall or the rest of the indexes must have a huge rally soon for parity to be restored. It is hard to believe that these 5 stocks can hold up this market for much longer.

[g18]

Nasdaq and other major indices may chop around these levels and perhaps the rest starts to bottom and head up. I hope so because the economy could do with a great deal of improvement and I think the market has an even chance of forecasting better days ahead.

[CEFspert]

"""State budgets will rack up $100 billion in deficits in 2020."""
Try at least 5x that, maybe 10x.

[AEGISBMD]

@CEFspert

Concur. Most states are required by law to have a balance budget. How they gonna do that? Especially with bonds for state and municipal projects about to get raped on their interest rates.

[kata]

They’ll have to cut their bloated budgets won’t they.

[CEFspert]

They'll have to cut Pensions, incl probably those of some SA investors
States need a new Natl Law to enable them to go Bankrupt and get Rid of Police/Fire-men who make 75-125% of their working pay (from 25-50)_ and then live off the state for 40 years incl double dipping on SS and getting free medical care.
No state can afford that
and all have made those promises.

[TheInsomniac]

We're going to have an L-shaped recovery, a hockey stick. The fundamentals are real. Mr. Market is simply experiencing Treasusy-boosted, irrational exuberance. It's going to be a turbulent ride, with equal highs and lows, with a slight trend upward, taking years of incremental growth to get back where it started.