One thing is clear. None of us have seen the U.S. economy shrink by 20-30% for a quarter or know what the aftermath will look like. Some of the zaniest strategists even seem to realize how ridiculous it is for them to target new highs for the S&P 500 and also forecast a depression, but they do it anyway. The Fed is everything to many of them. However, most stocks, Treasuries, and gold are not expressing the same optimism as big cap tech stocks that drive the S&P 500. Past cycles have demonstrated that a when the response to Fed action is not more uniformly bullish, caution is still in order.
Maybe our common sense is getting in the way of playing the “greater fool” game of simply buying regardless of valuations and hoping somebody down the road will pay an even more ridiculous price. It wouldn’t be the first time for us, but now it seems the suspension of disbelief required is higher than ever. We have to get a handle on earnings and cash flows first before making a major commitment.
Many of the folks that run businesses are not as optimistic as Wall Street either as they recalibrate operations to the current environment. Many are closing for good, never to come back. Big banks are ramping up provisions for credit losses by billions of dollars and industrial companies are not expecting a major improvement in earnings anytime soon, regardless of when lockdowns end. Big companies are skipping out on rent payments and borrowers are not paying mortgages in droves. The central bankers, pols, and bureaucrats can’t prevent these realities from unfolding.
Everybody wants to get back to “normal.” Let’s just be clear. We can’t wait to see a vaccine come along that stops the coronavirus in its tracks. We obviously have enormous sympathy for those out of work or ill. So, in that sense, we’d love to get back to normal too. However, the pre-virus financial environment was a bubble and was not normal. That is the most important thing to remember going forward. It was a highly levered bubble created by the Fed and Wall Street. Something was going to come along to put an end to it at some point. The virus happens to be the pin.
A deleveraging cycle must play out because there is simply too much debt in the system and not enough cash flows to support it. Stock valuations were not normal in early 2020. They were approaching 3 times normal. The Fed is acting hugely abnormally by making prior episodes of QE seem like a warmup just to make the 2019 bubble based on massive debt creation and stock buybacks seem normal. It has failed miserably since 2009 and is largely responsible for the circumstances in which we find ourselves because its policies encouraged the creation of massive debt and careless investment. It created a generation of investors that have been taught to ignore the risk side of the equation.
One thing that has clearly already changed is how involved the Fed has become in markets it used to leave alone. It is likely breaking the law by entering the corporate bond market. It has gone into command and control mode and will finance a likely $3-4 trillion dollar deficit this year. It will also buy municipal bonds. Businesses and consumers are relying on cash from debt created by Congress and bought by the Fed. These policies are surreal to us and we expected some version of this once this cycle concluded.
The Fed needs to provide a backstop. We agree. It does not need to crush free markets in the process or push investors out the risk curve to the point that they are exposed to huge losses. However, the Fed is now making it abundantly clear that it wants absolutely no free markets anywhere. It now wants to buy corporate bonds that fall below investment grade. That is absurd. Most of those companies were going to be downgraded at some point even before the coronavirus showed up. They should have been junk credits already based on their debt metrics. Capitalism only works when risk-takers enjoy gains and suffer losses.
Wall Street is expecting earnings to fall 30% this year and then bounce back in 2021 and so, of course, it is busy encouraging investors to look past all bad news as the Fed provides extreme amounts of liquidity. However, we think this environment is much worse than 2008. We remember waiting until early 2009 to increase exposures because we suspected the rally on all the policy actions would be tough to sustain while bad news from companies and the economy rolled in. That served us well. Most bear markets have an initial collapse and at least one powerful rally before another major selloff. Investors that are too early in thinking the worst has passed lose the most money.
This is going to be a long process, but investors appear to be benchmarking expectations to the idea that a switch will be turned and magically things will return to pre-virus days. We need to get a vaccine and testing in place to even begin to conduct business as usual in the U.S. Borrowing to consume will be frowned upon by a larger portion of consumers as many becomes more prudent, realizing that a savings cushion is wise. Meanwhile, past debts must be serviced with declining cash flows.
Transforming the old economy into one that is being run through the Fed, the Treasury, and Congress should give one pause in thinking that a return to the 2019 environment will happen anytime soon. Enormous amounts of additional debt are being created on top of the enormous amounts of debt that were already in the system. That will be a drag on growth just like it has been for the past decade.
We will let the credit downgrade and default cycle play out. Don’t get us wrong, we are highly constructive on the ability of many companies to ultimately power through the current crisis and prosper. We are just not willing to pay prices which don’t factor in the risks inherent in the operations of any enterprise, particularly in these highly uncertain times.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.