IS THE U. S. ECONOMY AT THE EDGE OF A PRECIPICE?

Federal Reserve Behavior--A Tell

During 2020 so far, the Federal Reserve on two occasions has lowered the Fed Funds rate between scheduled meetings--once is rare! Last week, the Fed announced that it may be purchasing BB-rated corporate bonds--that has never been done before!  Usually the Fed considers the "moral hazard"* implications before acting.  With this decision it has suspended that consideration. Desperate times call for desperate measures!

I have mentioned in previous blog posts that the "search for yield" would end badly. As interest rates have declined, financial managers have gone farther out on the risk spectrum to reap  higher yields there. The problem is that during a bear market the fixed income market for these riskier bonds has little liquidity.  Recently with bond prices up and stock prices down, financial managers want to rebalance their portfolios by selling bonds to buy stocks.  A financial manager whose fixed income portfolio is in high risk securities has trouble selling because there isn't a viable market.  The Fed's action will unclog that market.

The Fed's behavior signals its expectation of very bad news ahead!  It is trying to counter the negative wealth effect that a deep recession causes.  If both home values and stock prices decline significantly, owners will likely save more and  pull back on consumption, the main driver of the U.S.economy.

Right now, the Fed's ultimate concern is prolonged deflation, a condition few of us have ever encountered. Were that to occur, a vicious cycle might result.  To illustrate: a consumer interested in buying a house or car realizes that prices for those items are declining.  Why not wait for the lower price before buying?  The seller then lowers the price even more, which may encourage the consumer to wait even longer!  Given that the Fed had been unable to raise inflation to its desired 2% prior to the pandemic, its worry about deflation after the pandemic shock seems rational.  The Fed is fighting the tail risk of deflation. I applaud their action.

The Bad Scenario

1) The recession is very deep and lasts longer than expected.   Recent weekly claims for unemployment compensation suggest that the unemployment rate, recently at  50-year lows, may swell to a level only exceeded during the Great Depression!  That suggests a recession even deeper than the 2008-2009 Great Recession.  The shock from the pandemic causes the consumer to save more and spend less.  As a  result, the recovery from the recession will be much slower than expected--more like a  prolonged "U" than a "V."

2) President Trump's decisions are primarily motivated by one goal--to be reelected.  This introduces the risk that he will encourage a  premature lifting of  the sheltering-at-home and social-distancing restrictions now in place in most of the country.  In the best of all possible worlds, the scientific data, not political ambition, would dictate when to reopen the economy. That data involves extensive testing beforehand, which seems unlikely. So the recent plateauing of the virus may continue longer than expected before tapering off. The current price of the Standard and Poor's 500 Index (the "Index")  suggests that Wall Street is expecting a V-shaped recovery after a dismal second quarter.  

3) With few exceptions, Wall Street strategists have not yet built into their earnings estimates the reality of a prolonged  U-shaped recovery.  During the last two recessions, Index operating  earnings fell 32% and 56% respectively.  In 2019 earnings were 157. With those declines in mind,  2020 earnings should range between 107 and 69.  I expect  that actual earnings will be in the lower half of that range.

4) There is a second wave of the virus in the last quarter of 2020.

5) Due to the factors mentioned above, the Index retests the low on March 23; and the low fails to hold.

The Good Scenario

1) A  bona fide VACCINE is discovered soon and is fast-tracked for approval by the FDA--the GAME CHANGER!

2) President Trump listens to the scientists and doesn't urge lifting of the restrictions until adequate testing indicates the go-ahead signal.

3) The Fed's massive support program and fiscal stimulus approved by Congress eliminate the tail risk of deflation.

4) Trump's politically-motivated  decision to open prematurely proves prescient--whether due to warmer weather and/or a natural  tapering off of the coronavirus's cases. No extended first wave  and no second wave occur. A "V" recovery!

5) The Index never retests the low on March 23; that low proves to be THE BOTTOM!

Catching a Falling Knife

Stock markets discount the future. During a bear market resulting from a recession, the stock market will bottom before the recession is over. Bear market bottoms  form when fear reaches a crescendo. when investors tell their brokers “Get me out of stocks! I don’t care what the price!” That is known as the “capitulation phase.” 

Was the Index low on March 23 the capitulation phase?  In many respects this reminds me of October 10, 2008.  At that time TARP was just announced.  The volume of trading on that day was twice the recent volume, and 86% of NYSE listed stocks reached new lows. At that time I wrote that a breadth climax had occurred.  I was in the process of building an equity position, and I completed it soon thereafter.  As it turned out, most stocks did bottom on October 10, but the Index dropped another 26% before bottoming at 666 in March 2009.  The average cost of my equity position in 2008 was at an Index level of  1080. Compared with the previous bull market high above 1500,  that seemed like a good price,  and the position did well in the ensuing bull market,  However, compared to the Index low of 666, I should have done better!

Now a much larger Fed and Treasury effort than TARP and huge stimulus approved by Congress have been announced and will be implemented much faster.  Trading volume during the two weeks prior to March 23 was more than twice recent volume; and the percentage of new lows was 86%.  A breadth climax has occurred! But was that the Index low?

Bear market bottoms occur when there is an extreme of fear. Sentiment indicators measure the level of fear among investors. At extreme levels they are contrarian in that the higher their level the more bullish one should become. There are two sentiment indicators that are primarily relevant for traders: 1) On March 23 bearish sentiment at AAII was at levels last seen at the bottom of the last bear market in March 2009; and 2) the volatility index,VIX, was  at new highs. As an investor with a five to ten year horizon, I pay more attention to the percentage bears at Investors Intelligence’s weekly Survey of Advisors’ Sentiment. For the week ending March 20, that percentage reached 41.7%, not near the October 10, 2008 level of 53% and below the levels at each of the last five bear market bottoms. However, it is at the highest level in eight years! So the “fear gauges” were flashing a trading “Buy!” but not quite yet an investor “Buy!” As it turned out, a vigorous rally has ensued. 

What to do now?

With the great uncertainty that the pandemic has caused,  it is difficult to determine which scenario is more probable.  I am risk averse.  My inclination is to  go with the bad scenario.

In my Medium post entitled "A Case for Cash,"** published January 1, 2020, I suggested that both the Index and bonds were so overvalued that  they would produce subpar returns over the next ten years. So a large cash position was warranted until prices reverted to the mean.  At that point, the Index was at 3230.  In that post, I assumed compound annual Index earnings growth of 6.3% over the next decade. I assumed stock buybacks would continue to contribute one to two percentage points.  The Democratic party has been quite vocal against these buybacks, and that has become part of the current narrative.  Therefore I have reduced my expected annual  Index earnings  growth to 5.8%.   Were this rally to continue into the 2900-3000 range, I would reduce my equity exposure from 30% to 25%.  At 2950 the Index would generate a paltry 4.4% compound annual total return (including dividends) over the next decade.    

Given  my experience during 2008 and the lack of extreme bearishness,  I believe there will be a retest of the March 23 low;  and if the bad scenario becomes the narrative then,  a further downdraft might happen.  If the Index gets low enough,  I would raise my equity exposure to 70% in two tranches: the first 40% of my open-to-buy at 2,000-2200; and the remaining 60%  if the Index breaks through 2000, thus signaling another leg down.

*In the long run,  this Fed action encourages bad behavior.   Financial managers will expect the Fed to bail them out  again,  so why not buy the riskier bonds? And perhaps the Fed will buy stocks as well, so why not buy the Index no matter what the P/E multiple?  (Japan's Central Bank has tried this.)

**The URL is https://medium.com/@walterweil39/a-case-for-cash-e2819905137c