Jonathan V. Bever
A Return to Volatility #6
By: Jonathan V. Bever
Esse quam videri: (To be rather than to seem)
QE vs CV: Quantitative Easing verses Coronavirus
Deflation vs Inflation:
According to some experts, the possibility of negative interest rates is now on the table, even though the Federal Reserve Chair Jerome Powell said they are not considering this. Negative treasury rates, for some this will be an unthinkable event. The unthinkable or difficult to think about is not something we shy away from; rather, we believe it is our responsibility to do so. We understand this is a challenging time for everyone. Being isolated, one might imagine the best to the worst possible outcome. We hope to ease some financial worry as we continue our road map on our journey through the storm.
If rates become negative, ultimately finding investments with a real return will become more and more difficult. As you might guess those investments with the potential for a real return will attract the lion share of risk asset investments and potentially achieve very high valuations. On the other hand, as the cost of borrowing money goes lower, these companies could be taken private. Considering the new investment world, we live in, more sophisticated strategies may not just be a convenient option but necessary to protect the principal.
A common concern we hear: how can the market go up while GDP is going down? Does Wall Street just not care about economic fundamentals? It is a conundrum we shall address. At Fulcrum Wealth Advisors, we never forget that the economy and the stock market are two separate entities. Nonetheless, we argue if the economy continues to deteriorate, then the stock market will too; conversely, we argue, the opposite is true.
One of our ongoing theses: the growth of earnings, revenue, and dividends will drive stocks or market higher, and the decline of these will be manifest at a lower price. The following chart simply illustrates our first point. The orange line is the S&P and the black line going down is the GDP:
This is our 6th addition to the Return to Volatility. We will try to tie together some of the issues which have concerned us, we discussed and illustrated in prior blogs. Our aim: create a coherent picture, put a frame around the picture, and bring clarity.
The following is another example of an economic index going down while the market is going up. This is called the ISM or Institute for Supply Management Index. The green line in this chart shows the ISM manufacturing index. A number above 50 is a sign of growth and a number below 50 is a sign of contraction. The number now is 45.5. There are times the ISM deteriorates while the market shrugs it off and goes sidewise or higher. The low of 2008/2009 was 34.5: we would not be surprised to see this number again. Likewise, we believe we cannot say with confidence we have seen a bottom to the market until the economic numbers begin to improve.
The advent of QE in 2008 became a game-changer regarding price discovery as it tends to lift asset prices. We have argued for several blogs that QE would return; QE is the money put on the Fed balance sheet to create liquidity and bail out the economy. We called the “printing money” (QE), a Faustian Deal from which getting away would be nearly impossible. QE is magic money. We argued, in order to print money inflation must remain in check. We focused on oil price inflation; however, labor inflation is a larger percentage of inflation and would be an obstacle to QE. Now in the coronavirus pandemic, both of those obstacles have been removed. As we expected QE has come back with a vengeance.
Please see the chart:
Many of the things we predicted have played out: rising rates cycle to lower rates; Quantitative Tightening cycle (reducing Fed balance sheet), to Quantitative Easing (additional assets on the Fed balance sheet; normal yield curve, to flattening yield curve, to a steeper yield curve; an expensive Price to Earnings P/E on the stock market to a lower P/E, and back to a high P/E; a strong economy to a recession.
Please see the following chart: the top line is the Fed balance sheet. The middle line is the Fed Fund target rate.
In short, our thesis regarding Fed policy has largely played out. So, what is next? To answer this, we will look at more economic facts.
Let’s look at the unemployment number below:
States generally pay the unemployment benefits. This time there is an unemployment enhancement paid by the Treasury, so some are making more money being unemployed. What concerns us: how will states continue to pay as the unemployment is historically high, and states are not getting the same amount of tax revenue? Will the states run out of money to pay the unemployment checks? We feel confident in saying, unemployment benefits will be yet another financial issue to address. The current answer to everything financial: print more money! Will states ultimately have to borrow more from the Treasury? Will this have political ramifications?
We are confident, all the money printing will ultimately lead to inflation; this may take a couple of years. We hope that it will not lead to hyperinflation. Serious inflation during a recession would be extremely painful; inflation during a recovering economy could be stifling.
We have been writing a series on the theme of a return to volatility for over 2 years, as we have anticipated an increase in market volatility. Our focus, to get at the cause. While we are pleased to be correct in our anticipation QE and rate cuts, we are saddened by one of the catalysts for an increase in the amplitude of volatility: the coronavirus. This virus is wreaking havoc to families and economies throughout the world. Insight to navigate what we believe is a complex set of variables affecting the market is imperative.
As mentioned, many notice the disconnect between the stock markets rise from the low, while the economy continues to deteriorate. Is it just a classic Wall Street versus Main Street issue, or is there something else going on? To our surprise, the stock market is just as expensive as it was in January as measured by a P/E ratio. This is a conundrum that demands exploration.
People seem to fall into one of two extreme camps of thought regarding this contradiction:
One camp: the bear market is over, and the market rally is telling us this; the coronavirus damage will be short-lived: called a V “recovery. “We believe this is highly unlikely.
Another camp: the bear market is just getting started and the market rally is one to sell; the coronavirus has no short-term end insight, and the damage to the economy will continue and ultimately be felt in the stock market: called an L “non-recovery.” It is a down and sidewise economy. We believe there is a tug of war between money printing (QE), the rise in the stock market, and the deterioration of the economy; how this plays out will be hard to guess. Of course, a sudden cure for the coronavirus would be a win for everyone.
We strongly caution investors to be more acutely aware of the risk in risk assets. In addition, we caution listening to simple antidotes comparing this period to prior periods in our lifetime. We have never lived through this before and to predict an outcome around unknown variables is someone’s guess at best. The stock market, like the economy, is a complex system; in order to gain better insight into the system (any system), there is a need to distinguish between truly random behavior and behavior caused by other unknown factors. A reasoning agent thinking they have all the factors and is missing just one will end up being far off.
Many arguments we hear are fallacious (a logical fallacy). An argument with a contradiction is not valid. The common argument we hear is usually Argumentum False Cause. Such as in 2008/2009 there was an unusually high number of “something” (you fill in the blank), and today we have the same number of “something,” therefore we are calling a bottom to the market and investing money. While they may end up putting money to work and it may go up but not for the reasons they suggested. If it goes up, why do we care? To this question we will answer with a quote from a famous pre-Socratic, Heraclitus: “The road up is the same as the road down.” We have argued, a solution to solving the problems of 2008/2009 called Quantitative Easing, did not solve the economic problems; rather, it was merely postponing the problems. Again, the solution today is more QE; the unintended consequences once again will be felt at some point down the road. Again, we believe it will be inflation, and we hope it is not severe inflation.
This contrast gets at the core of our beliefs regarding investing. We look for a high probability of value for our investment recommendations.
There have been periods of time where discretionary spending was low because of a lack of confidence in the economy. Spending on unnecessary items was curbed. For now, this is the environment we live in which could last months or much longer than we currently imagine. We categorize business into two main categories: the necessary and the unnecessary. And under that umbrella, we categorize businesses into the loved, liked, and ignored.
The loved and necessary we anticipate having the highest probability of return as they ought to be the recipient of increasing business revenue. Further, the unloved and unnecessary maybe the best value for the longer-term investor. We believe the valuation of a company should be based on the potential growth of the company no matter how that is dissected: future free cash flow, future revenues, future earnings per share, etc.
To sum: even though we had a shaking on the stock market, the market is still expensive. As the earnings are being revised down the market is potentially very expensive. Further, the economy is bad, and the effects will be felt for a long time. So, risk management is paramount. Earnings, revenues, and dividend forecasts will have major adjustments.
We argued in Blog 5 that the valuation of the market was high and that there are times when valuations are downright treacherous. However, as the Fed had implemented Quantitative Easing in 2008, zombie companies were kept alive and price discovery evasive. Likewise, a higher than average P/E on the S&P became the norm. The coronavirus came and popped the bubble and market volatility skyrocketed. Then the Fed came to the rescue with more QE, and the market stabilized. We argued QE was coming back in several prior blogs, which had nothing to do with Coronavirus; rather, it is because of unaddressed debt issues from 2008/2009.
The repercussions of economic policy have yet to be totally understood. No doubt it will play out in the next few years. Now more than ever stock selection is imperative.
Thesis: just like war takes several years to work through, so will getting through the coronavirus war. Personal loss, financial, emotional will takes its toll. The stock market will fluctuate as the economy remains in flux between recession and recovery. We don’t think we will enter a depression as the government is all too ready to print money; we are grateful for this. However, perhaps in a few years as we have the coronavirus under control, and we are back to work, back to flying to other countries for a vacation, taking cruises, the unintended consequence just might be a lot of inflation. This inflation will likely lift risk assets to new highs, and crush bonds that have treacherous valuations. There is no way to time this or we could get out now and get back in; we don’t see this as a good strategy. Investment cycles seem to run their course much faster than ever. I have heard a Wall Street axiom, “they don’t ring the bell at the top and they don’t ring the bell at the bottom.”
SPX INDEX: S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices, and many consider it to be one of the best representations of the U.S. stock market. GDP CURY INDEX: Gross Domestic Product (GDP) is the monetary value of all finished goods and services made within a country during a specific period. GDP provides an economic snapshot of a country, used to estimate the size of an economy and growth rate. GDP can be calculated in three ways, using expenditures, production, or incomes. Apr 29, 2020, Investopedia
ISM Manufacturing Index, which used to be called Purchasing Manager's Index (PMI), measures manufacturing activity based on a monthly survey, conducted by Institute for Supply Management (ISM), of purchasing managers at more than 300 manufacturing firms. Apr 24, 2020, Investopedia
Quantitative easing (QE) is a monetary policy whereby a central bank buys government bonds or other financial assets in order to inject money into the economy to expand economic activity. Wikipedia
The Fed Balance Sheet
FEDL01 Index: Until March 1, 2016, the daily effective federal funds rate was calculated by the New York Fed as a volume-weighted mean of overnight rates on trades arranged by major brokers. As of March 1, 2016, the New York Fed is reporting the daily volume-weighted median value of trades provided by the brokers. All rates are subject to revision by the New York Fed. Bloomberg
FEDL01: is a spliced series of the mean-based calculated values of the effective rate (prior to March 1, 2016) and the median-based calculated values of the effective rate (from March 1, 2016).
NAPMPI Index: The PMI is compiled and released monthly by the Institute for Supply Management (ISM). The PMI is based on a monthly survey sent to senior executives at more than 400 companies in 19 primary industries, which are weighted by their contribution to U.S. GDP. The PMI is based on five major survey areas: new orders, inventory levels, production, supplier deliveries, and employment. The ISM weighs each of these survey areas equally. The surveys include questions about business conditions and any changes, whether it be improving, no changes, or deteriorating. Investopedia
4.1 report: This provides a consolidated statement of the condition of all the Federal Reserve banks, in terms of their assets and liabilities. ... It lists all assets and liabilities, providing a consolidated statement of the condition of all 12 regional Federal Reserve Banks. May 11, 2020, Investopedia
CPTICHNG Index: Capacity utilization tracks the extent to which the installed productive capacity of a country is being used in the production of goods and services. For some countries, this concept is reported as the percent of capacity being used for production (as opposed to sitting idle). For other countries, this concept is measured through business surveys (tracking business leaders' opinions on their use of productive capacity). Bloomberg
In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements. Wikipedia
FARBAST: This concept tracks the aggregate assets and liabilities of banks within an economy (including private or commercial banks, central banks, or both). Bloomberg
USURTOT Index: The unemployment rate tracks the number of unemployed persons as a percentage of the labor force (the total number of employed plus unemployed). These figures generally come from a household labor force survey. Bloomberg. Unemployment occurs when a person who is actively searching for employment is unable to find work. Unemployment is often used as a measure of the health of the economy. The most frequent measure of unemployment is the unemployment rate, which is the number of unemployed people divided by the number of people in the labor force. Investopedia
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All charts courtesy of Bloomberg Finance L.P.
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