When the market is confusing, it’s always important to remember that the economy and the market are two different things. Corporate revenues and interest rates are important inputs for both, but beyond that, most factors impact the economy and the market in an unequal fashion. There are three main causes for divergences between the economy and the market: timing, profitability and size. Given the appearance of a major disconnect between the ebullience of the stock market and the dire state of the economy, we think it is helpful to dig into some of the justified causes of the divergence.
Timing divergence refers to the forward-looking nature of markets. We tend to think of the economy as unfolding in the present, but markets are focused exclusively on the future. To the extent that the economy is terrible now, the chances of significant rebound in economic activity increase. The expectation of incremental improvement tends to bolster stock prices.
Profitability divergence refers to the occasionally perverse relationship between headlines that are objectively bad for the economy, but good for the possibility of future profitability. For example, when company X announces that they will be laying off 10% of its workforce, it is not uncommon to see company X’s stock price rally on the news. Nobody likes seeing massive layoffs, but when company X cuts its labor cost dramatically, the odds of company X turning a profit despite a bad economy improve.
Size divergence refers to the fact that even small publicly traded companies are gigantic compared to the typical small business. To the extent that stimulus plans and government policy benefit large companies over small companies, the stock market is likely to rally disproportionately. It’s hard to ignore just how unfair the recent policy and stimulus have been to small businesses relative to larger businesses. To use an extreme example, think about a small bookstore trying to compete with Amazon over the past 3 months! The reality is that many small businesses that were already struggling to compete against larger, more technologically advanced, competitors are likely to go out of business. With fewer competitors, the larger survivors are likely to benefit yet again. In other words, the rich get richer.
All three divergences support stock prices currently. That said, we still come down on the more bearish side. But, right now, bulls and bears can’t even agree on the facts. This quarter we will take a closer look at the two opposing perspectives on the stock market.
- The Quarter in Review
- Sentiment & Value Update
- The Bear Case
- The Bull Case
- FC Advisors’ Take
The Quarter in Review
Both US and international stocks continued to rally at a torrid pace supported by optimism around vaccines and re-opening global economies. In May, for the first time since its inception in 1913, the Fed began buying securities that are not guaranteed by the US government. This new step in monetary stimulus further bolstered stock prices. Many Fed watchers (and frustrated bears) alleged that this act violated the Fed’s charter, but the rally rolled on. Meanwhile, the bond market stood stubbornly in place, continuing to price in the possibility of renewed economic contraction and deflation.
Relative Index Performance
Total Returns as of 6/30/20
Sentiment & Value
This truly was one of the most bizarre quarters in the history of capital markets. Beyond the extreme divergence between the stock market and the economy, we witnessed a rebirth of day trading reminiscent of the late 90s. In particular, investors started recklessly buying up shares of companies that were either in bankruptcy or on the verge of bankruptcy. For the uninitiated, when a publicly traded company declares bankruptcy, it is common for the bankruptcy court to wipe out the equity holders entirely. As if that wasn’t enough, two massive international frauds (Luckin Coffee & Wirecard AG) each with market values above $10B were exposed. In both cases, management reported hundreds of millions of dollars’ worth of fake sales that auditors signed off on.
Wild speculative activity and fraudulent businesses tend to occur before market peaks, not within weeks of the bottom. In other words, it is still possible that the stock market bottom is not in yet. This speculative activity and the still incalculable level of economic uncertainty have us once again in a conservative position. All things being equal we are buyers of US stocks below 2,900 on the S&P 500.
The Bear Case
If you squint, you can see the uptick in employment that has occurred since April. With just under 138 million people employed in the US we are at the same levels that we were in February of 2014 (S&P: 1,836), May of 2008 (S&P: 1,376) and April of 2004 (S&P: 1,484).
The bears main point is that based on anything near current employment, our economy is over supplied with all sorts of goods and services ranging from office space to legal services. Moreover, this recession has been unlike previous recessions in a very important way. Normally, cylcical industries (e.g. auto manufacturers) and consumer discretionary (e.g. jewelry & electronics) are the epicenter of job losses and oversupply. Typically, when these cyclical industries struggle, service industries like restaurants and bars and hair dressers help to carry us through the recession.
However, in this recession, the epicenter has been in service industries. With so many people out of work and demand for many cyclical & discretionary items falling, does the US economy face a second wave of unemployment as cyclical businesses “right size” down to this lower level of employment? Many bears believe so, which suggests that a retest of the recent lows is still to come. In a global depression, there is no reason the S&P could not fall more than 50% from its current sky high valuation.
Lastly, the bears point out that even with a significant recovery, we will eventually need to pay the bills on the $3T+ deficit caused by the stimulus. The Biden platform currently calls for rolling back Trump’s corporate tax cuts and boosting capital gains taxes. Trump’s tax cuts boosted earnings by more than 20%, powering the massive rally through 2017. Reversing these tax cuts would reduce earnings by at least 20%, therefore, even with strong recovery the S&P should be trading 20% below the February highs. S&P 500: 2,714 at best.
The Bull Case
That fine gentleman above is Dave Portnoy, founder of Barstool sports and one of the figureheads of the new do-it-yourself day trader movement. Highlighted above is Mr. Portnoy’s first rule of investing: “Stocks only go up.” Rule two: “See rule #1.” Seriously. He does live broadcasts at the open and the close of trading every day and his favorite investment themes are airlines and cruises, on which he has made some excellent returns since March.
To be fair, Mr. Portnoy’s routine is at least partially tongue-in-cheek and most of his audacious statements seem to be meant mostly to attract attention. That said, what appears to be a boneheaded investment philosophy, might belie a deeper understanding of our current predicament than most of his critics are willing to give him. What if the game is rigged, at least for the next year or two?
The crux of the bull case rests on the Fed and congress providing massive stimulus until the economy can grow and create jobs on its own. To the extent that congress and the Fed are so desperate to maintain the status quo, that they will not permit a significant downturn (down 15%+), Mr. Portnoy may be on to something! If the Fed has taken downside risk off the table, then equities are less risky, suggesting that the price should be higher. With the 10-year treasury paying 0.68%, how much should the earnings yield (earnings per share/price) be on the S&P 500? Why not 4%? Analysts, who tend to be bullish, are penciling in $164 of earnings per share on the S&P 500 for 2021. A 4% earnings yield would imply that the S&P 500 should trade at 4,100.
That might seem like a pretty flimsy investment case, but the bullish case almost always sounds flimsy compared to the bear case. Some of the best investments of the past decade have basically boiled down to “dude, who cares how much it costs, the internet is going to grow so much!” Don’t fight the Fed.
FC Advisors’ Take
Remember last quarter when we said the Fed was ill equipped to combat the Covid recession? Well, that was before they violated the language of the Federal Reserve Act of 1913 and the language of the recently passed CARES Act. If Congress will not force the Fed to adhere to the law, there is no stopping the Fed from eventually buying stocks if they deem it necessary. Additionally, the market has become conditioned to buy when the Fed intervenes to prop up prices.
The rules of the game have changed, and we must be prepared to adapt. While we believe that markets are significantly overvalued, the Fed, with the help of Congress, is likely to be able to reduce the downside for financial markets. In this case the divergence between the market and the economy is likely to continue growing. Therefore, while we lean bearish, we believe that charting a more “middle of the road” course is necessary because we expect any selloffs to be smaller and shorter in duration than history would otherwise suggest.
Until the Fed is forced to the sidelines, we have to relax our estimates of fair value. So, what could force the Fed out of the game? Rising inflation would do it, but that may be a few years away. But there is a growing narrative that could sideline the Fed indefinitely… Inequality. The Fed wants us to believe that its policies promote full employment and that more jobs means less inequality. But the Fed doesn’t create jobs, the only real power the Fed has over the economy is to manipulate the price of financial assets. It’s going to be a few years before we are back at full employment, so in the meantime, who disproportionately benefits from the Fed pushing the price of stocks and bonds higher?
If Congress begins to take action to reign in the Fed due to the inequality that its policies perpetuate, we will become decidedly more bearish. Until then, don’t fight the Fed.
If you would like to dig through the Fed’s data on household wealth distributions yourself, you can do it directly here.
There are lots of great charts and graphs. You can even look at how the data have changed since 1989.
If you have questions about these topics or any other financial needs, please contact
FC Advisors at:
Following Claire Advisors, LLC DBA FC Advisors is a Registered Investment Adviser. This brochure is solely for informational purposes and is not intended to provide investment advice. Advisory services are only offered to clients or prospective clients where FC Advisors and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by FC Advisors unless a client service agreement is in place.