One City Crumbles, While The Other Thrives

Summary

• The real economy is crumbling under the weight of a deep recession, ongoing pandemic and nationwide protests.
• The stock market is marching towards its all-time highs.
• This dichotomy is unsustainable.
• The stock market will ultimately reflect a fundamental outlook that is far more dire than what prices indicate today.
• This idea was discussed in more depth with members of my private investing community, The Portfolio Architect. Get started today »

This year has been a tale of two cities like no other. As the economy literally crumbles in violent protests across the country, and a pandemic continues to rage on, the stock market climbs daily towards its all-time highs. I don’t know whether I should be buying stocks today because the phase-one trade deal with China is falling apart, or because Gilead’s (GILD) latest results show Remdesivir isn’t as effective in treating COVID-19 as originally hoped, or because the most recent horrific economic data points were slightly less horrific than expected.

I’m desperately looking for positive news that isn’t disguised as the kind of temporary relief someone who is drowning gets when they momentarily resurface for a single breath of air. The reality on the ground is a disaster, and it isn’t getting better any time soon, regardless of the hypnotic spell the Fed has put on investors to ignite a liquidity-induced melt-up in financial asset prices. The crisis facing millions of small businesses in June isn’t reflective of a recession, but a depression, because millions of them will not survive. It seems to be lost on the bullish consensus that these are our job creators.

As for those generous unemployment benefits intended to keep Americans afloat, it turns out millions haven’t received a dime yet because of an outdated and inefficient system that is still sending passwords to people by mail. The Treasury has yet to pay $67 billion in claims dating back to April. That’s a long time to survive on a $1,200 stimulus check, if you are unemployed.

Yet the Fed’s answer to the economic collapse is to keep pumping the financial system with liquidity that it doesn’t need, for no apparent reason other than to monetize our exploding deficit and keep a constant bid under stock and bond prices for fear that reality may poke a hole in the Ponzi scheme it calls a free market. As a result, bullish investors are now seemingly convinced that fundamentals don’t matter, because the Fed will indiscriminately buy whatever they do and keep prices rising. I contend fundamentals don’t matter, until they do.

Consumer incomes are what stimulate demand for goods and services in our economy. That demand leads to corporate profits, which result in business investment and more job creation. The additional job creation further increases overall consumer income, which leads to incremental demand for goods and services, fueling the cycle in a positive feedback loop. That is how the economy works. Stock prices reflect the profits that companies earn over the long term, and those profits are dependent on jobs and the incomes they create.

We will lose tens of millions of jobs this year, and they will not be recovered in the year that follows. Therefore, it is fantasy to expect the corporate earnings recovery that the current stock market rally is anticipating today. To disregard the linkage between jobs, incomes, spending and economic growth with corporate profits is short-sighted, but that’s the line of thinking the Fed would like you to maintain.

The greatest scam the Fed continues to play is convincing the public that its crisis-era policies foster job creation when they do not. In fact, they do the exact opposite by promoting malinvestment, which is what leads to asset bubbles, like the one we have today. The Fed wants to create the appearance of a strong economy through inflating financial asset prices, regardless of whether those prices accurately depict the fundamentals they represent, in the hope of influencing corporate and consumer sentiment. The asset bubbles ultimately lead to price instability, which runs completely counter to the Fed’s mandate of stable prices.

The dichotomy between investor euphoria and economic fundamentals, depicted in the chart below, is as stark as I have seen in my 28-year career. Regardless, Wall Street firms like Goldman Sachs are sheepishly rolling back their fundamentally-based downside targets for the S&P 500, because they are overwhelmed by the short-term bullish price action of the market. This is akin to a short-covering research call, because they can’t take the pain of being wrong for too long, so it is better to give into the trend and be its friend. They are capitulating to the Fed’s primary objective and feeding the frenzy.

In turn, bullish investors are focusing on the few economic indicators that appear to be bottoming. They see that stabilization as a green light to invest before financial markets fully discount the anticipated improvement ahead. Today, that improvement comes in the form of a new high in S&P 500 corporate profits in 2021. You just must ignore the collapse in profits in 2020.

You must also ignore the fact that the economy will have millions fewer jobs in 2021 than it did in 2019, as well as declining income, spending and economic growth. If the entire economy were to fully reopen today, it would not mean we would have 100% of the economic activity we had at the beginning of the year. If we were to recover 90% of our economic activity, it would be a major feat, but that is highly unlikely. An economy running at 90% of its 2019 capacity would result in an economic contraction twice as bad as what we experienced during The Great Recession. Again, the forecasted earnings recovery that this stock market rally is based upon is delusional.

While it is true that the stock market has historically bottomed several months before recessions end, buying stocks at current valuations into the depths of this recession is like swimming into a tidal wave. That tidal wave comes in the form of a forward P/E multiple for the S&P 500 that has topped the levels of the past ten years so that it is practically off the chart. If we use a realistic 12-month forward estimate, instead of today’s $128 consensus estimate, then the multiple would literally be off the chart.

I don’t know anyone in their right mind who would invest long term in the broad market at these valuations. I always maintain a core weighting in stocks, and I’m still above that core weighting based largely on the rally in the broad market, but I continue to reduce my exposure as the market moves further and further away from the real economy.

Analyst’s Disclosure: I am/we are long GILD. 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.

Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.