Evaluating the sustainability of the recent bounce in U.S. stocks.
A pragmatic perspective on some optimistic assumptions.
You have one week to decide on any substantive changes to your portfolio before the economic and financial news flow really starts to pick up.
The U.S. stock market is finally back. After smashing the bear market speed record and falling by more than -35% over just twenty-three trading days since February 19, the S&P 500 Index finally found a bottom on Monday, March 23. Over the two trading days since, U.S. stocks have bounced by as much as +17%. The bounce appears to be on. But for how long? And what’s next after this initial bounce?
How do we know whether this bounce will continue? Only time will tell, as this market remains highly unpredictable, but a few key indicators are signaling that this bounce may have further to go.
First, with the bounce that started on Tuesday, the S&P 500 Index definitively broke out above its steep downward sloping trendline.
This stock market bounce was foreshadowed as early as last Thursday by the CBOE Volatility Index, also known as the “fear” index. The VIX first broke its uptrend dating back to the stock market peak during the up day last Thursday. And while stocks fell hard on Friday and Monday, the VIX continued to drift lower. This suggested that while selling pressure was persisting, the investor fear and mass liquidation pressures that had been gripping the market were finally subsiding.
Is this the latest “buy the dip” opportunity for long-term investors? This is where things start to get tricky for investors. If you came to investing for the first time over the past decade, the only stock market you have ever known is one that does the following:
Put simply, whenever the stock market fell for any sustainable amount of time, this was the long-anticipated buying opportunity to capitalize upon. For whenever stocks started to fall, you just knew it was only a matter of time before policy makers would come to the rescue with promises of that latest shot of monetary adrenaline that would eventually jolt stocks to new all-time highs.
So where are we today in this regard? The economic situation sure looks dire today. But it has looked pretty bad on a number of occasions over the past decade, and each and every time the Fed pulled off the market stick save. And look at the amount of stimulus that the Fed is rolling out today. Unlimited QE. Monetizing everything in sight except for stocks (and let’s be real, we all know it’s only a matter of time before they’re buying stocks, right?). The actions of Jay Powell and today’s Fed would leave Ben Bernanke and the FOMC from the Great Financial Crisis blushing. How can this not be the force that eventually drives stocks to new all-time highs by the end of 2020 once the coronavirus has become a distant memory and the global economy has roared back to life?
Perhaps this notion will prove correct. Perhaps what we are seeing today is simply the latest iteration of the Fed stock market stick save. Perhaps this will be their most extraordinary work yet. But what if, after a decade of seeming invincibility, policy makers and the U.S. stock market have finally met their match?
A pragmatic perspective on some optimistic assumptions. I have a decidedly different view on what I believe lies ahead for financial markets. I maintain this view for several reasons, which I have outlined below.
Today’s economic challenges are different from the financial crisis. Back in 2008, the Main Street economy was generally doing just fine as evidenced by the following quote.
“Well, I do remember one conversation I had where I was addressing a caucus of congressmen. And a congressman said to me, ‘Mr. Chairman, you know, I’m talking to bankers in my town. I’m talking to shopkeepers in my town. And they say things are normal. Nothing’s going on. We don’t see any problem.’ And I turned to him and I said, ‘You will,'” Bernanke recalled.
–Fed Chair Ben Bernanke, 60 Minutes, March 2009
Instead, the crisis in 2008 was a paper problem, as a whole bunch of knuckleheads in the financial industry got way too far out over their skis with leverage and risk taking. It was Long Term Capital Management from ten years earlier in 1998 on a mass scale. The system seized up at the expense of the economy. And the Fed needed to reliquify the system to get the economy going again. In short, it was a supply problem originating in the financial system. It was not a demand problem.
Today, we have a demand problem of unprecedented proportions. Assuming Congressional representatives are talking to bankers and shopkeepers in their respective towns, they are saying over their phones as they stay-at-home that this is unlike anything they have experienced in their lifetime. Their entire local economy has effectively ground to a halt. In short, it is a demand problem, it is a supply problem, it is a flat out problem of epic proportions. And regardless of whether the Fed reliquifies the system or not with a huge fiscal assist from the U.S. government, we still have no idea when shopkeepers will reopen and when their customers will start showing up again when they do. Unfortunately, the same holds true for the largest corporations not only in the U.S. but across the world.
This is not a stimulus; it is a rescue. There’s a reason why everybody keeps saying that both the Fed and the U.S. government are going to need to do a lot more going forward. Because the money that is pouring into the financial system right now is not a stimulus designed to give a boost to already existing growth. Instead, the Fed is fire hosing liquidity into the financial system to prevent it from collapsing. The Fed isn’t trying to artificially inflate asset prices in order to create a “wealth effect” like it had over the past decade. Instead, the Fed is simply trying to buy time until fiscal policy makers can act and provide support in ways that they simply cannot.
Failure is an option. This is not the financial crisis. While banks are clearly under pressure today, they do not reside at the epicenter of the problem. And they are collectively vastly better capitalized with much less leverage and higher quality loan portfolios than they were twelve years ago. This doesn’t mean that a group of banks are not going to get taken out before it’s all said and done. But this is not a financial problem today.
Instead, this is an economy wide problem. And with the economy completely shut down, it is quickly becoming an insolvency problem. The Feds cannot rescue everybody, nor should they in a capitalist system regardless of the underlying cause of the economic recession. And the companies most at risk today are those that are either not systematically important to the economy or are highly capital intensive.
What do I mean here? A recent example from our ghosts of crisis past for an example of an important company, but not a systematically important one. If General Motors goes bankrupt as it did during the financial crisis, it does not imply the collapse of the economy. The assets are still there. The workers still have the skills to run the assembly lines. And the management teams still know how to run the business. It’s just that the company no longer has the capability to service its debt and meet its interest payments. What happens in this case is that the owners (shareholders) are wiped out and the bond holders take over the company to figure out what to do next. Now in the case of an important company like General Motors that has tons of feeder suppliers and manufacturers that are highly dependent on the automaker host, the government may get involved to dictate how the bankruptcy is resolved. And while the company was streamlined in the process, it still operates as a major U.S. company today, albeit with new ownership.
What about those companies that are not important? If you’re operating in a cyclical business such as retail or entertainment or lodging and with assets that could easily be auctioned off without much disruption, and you are not best of breed and/or investment grade rated, then your outlook is extremely challenged in the coming months. This is particularly true if you were operating your business with a high amount of leverage and debt.
So while the Fed can enter the marketplace and buy up corporate bonds in order to provide liquidity, they can only do so much to help an company facing solvency and liquidity risks to meet their interest and debt payments. Even if the rules are relaxed, a good number of companies that were previously deemed to be “safe” with “sufficient cash on hand” are likely to enter bankruptcy in the coming months.
The buyback pitchforks are coming out. Corporate share buybacks have been the primary if not exclusive driver of the post financial crisis bull market in stocks. And regardless of whether a cogent intellectual argument can be made about the value that is added from corporations repurchasing their shares, a fairly easily digestible counternarrative about how share repurchases effectively enrich corporate CEOs at the expense of the long-term financial viability of their companies is increasingly taking hold. One has to look no further than Boeing that took on mountains of debt and deployed billions of dollars in cash flow not to increase capital expenditures on a per share basis but instead to ship this money back to shareholders in the form of stock buybacks and dividends only to find themselves in desperate need of cash just like this amid liquidity and solvency crisis the moment the U.S. economy turns south. With companies like Boeing doing the heavy lifting for them, the progressive politicians that have been railing against stock buybacks for years are likely to have an increasing roster of easy targets to make their point.
Corporate earnings have yet to be revised lower in any meaningful way. On February 21 when the market was effectively at its peak, U.S. stocks were forecast to generate quarterly per share earnings on GAAP basis of $35.28 per share in 2020 Q1 and $38.92 per share in 2020 Q2. Almost exactly one month later on March 20 after the global economy has effectively ground to a halt, U.S. stocks are forecast to generate quarterly per share earnings on GAAP basis of $33.70 per share in 2020 Q1 and $36.07 per share in 2020 Q2. These are downward revisions of just over -4% in Q1 and -7% in Q2. I’ll just put it this way. Forward earnings estimates for the upcoming quarters need to come down A LOT from where they are today. I repeat – A LOT.
COVID-19 may not simply be a matter of “when we get back to normal”. I hear a lot of financial prognosticators proclaiming the following: “once the coronavirus has past and we get back to normal, the economy will be set to boom in the second half of the year”. Man, I hope they are right, but I just don’t see it playing out that way.
Consumers and businesses are likely to be very tentative for some time once the all clear signal has been sounded and people are able to freely venture out again. All that has taken place in such a short period of time has been highly unsettling and agoraphobia inducing. Not to pick on the President, but even if the coronavirus magically disappeared tomorrow, I’m not sure churches would be packed come Easter anyway. Many people have been forced to take a good hard look at their financial circumstances at a time when they are afraid to simply go outside. In short, this is going to be a tough one to come back from initially from an economic perspective, and much tougher than post 9/11.
Also, even if the stay-at-home calls are lifted and businesses are allowed to reopen, this does not mean that the COVID-19 risk simply goes away. The risk of a second wave will likely loom for months afterward. And even if it turns out that warm weather meaningfully suppresses the spread of the coronavirus, it is going to get cold again in this country come late next fall and into the winter. With this cold will come an added set of potential risks associated with our current episode that frankly I just don’t want to think about right now. Either of these second wave risks have the potential to send us back into another prolonged stay-at-home phase for months after the current episode passes. This threat alone is not good for the economy, much less it actually taking place for a second or third time around.
COVID-19 is not the only major shock the markets are dealing with right now. Largely overshadowed by a global health contagion is the fact that an OPEC+ oil price war erupted along the way. It is worth noting that it was a similar oil production decision by Saudi Arabia starting back in late 2014 that sent global financial markets for a wild ride and Fed stick save requiring tailspin for the next 15 months through early 2016. Today, we have an even more dramatic oil price war playing out today, yet it is largely an afterthought. But regardless of whether it is getting the attention it would deserve in most any other news cycle, it is a huge container of gasoline being poured on an already raging fire across capital markets with prolonged effects in its own right.
Don’t get me wrong. I fully believe that we as a country and a society will overcome this global health risk. We will persevere, and I believe that we will be stronger for it and much better prepared for the next time around, which will help greatly mitigate the risk of something like this happening again in the future. I firmly believe that this will all pass and everything will be OK again. But this doesn’t mean that I think the U.S. stock market needs to be trading at all-time highs or anywhere remotely to it for us to realize this final outcome. For example, the South Koreans have done a relatively exemplary job of confronting and managing the COVID-19 crisis to date, yet their stock market today is still trading nearly -20% below highs reached all the way back in 2007. The relationship between the economy and the stock market much less the outcome of a global pandemic weakened a long time ago once the Fed got into the game of juicing the stock market more than three decades ago.
You have one week to decide. Maybe you read all of these above risks and shrug your bullish shoulders. Perhaps you subscribe to some of the risks above, but dismiss others. Maybe you are deeply concerns about the downside risk prospects for capital markets. If you are undecided, or if you have been biding your time waiting for the bounce, now is the time to be thinking about your exposure to risk assets going forward. For once we get toward the end of next week, things for financial markets are about to get REAL real.
Up to this point, we have been moving through what is a traditionally quiet period of the quarter, particularly during the second half of March. The flow of economic and market data is minimal, and much of it is getting dismissed now anyway as it reflects conditions that were in place prior to the onset of COVID-19 in this country. And this quiet period will continue into next week.
This will all change come next Friday, April 3 when the monthly job report for March is released. From this point on, investors will increasingly be forced to take a look at a steady data showing how much damage the U.S. economy has sustained thus far.
Moreover, 2020 Q1 earnings season will quickly get underway starting the week of April 6 and picking up quickly through the remainder of the month and into May. This will not only include companies reporting on how they fared with the operating disruption at the very end of the first quarter, but they will also be issuing guidance (whatever this will be worth) on what they expect from their businesses in Q2 and beyond. All of this information is almost certainly going to be deeply troubling. The only question is exactly how troubling. But if the fact that current earnings forecasts remain as high as they are suggests a lot of space exists for investors to be negatively shocked while seeing their forward P/E ratios explode through the roof. The degree of solvency risk facing many companies will come increasingly into view during this time period as well.
So while hopes may be high that we may have bottomed on March 23, the likelihood instead is that we may have hit our first bottom in a series of successive bottoms that may extend out for some time into the future.
So how much further should we expect the stock market to bounce? Technical analysis helps inform our fundamental decision making. I am currently monitoring five key levels on the S&P 500 Index over the coming week. Three are Fibonacci retracement levels that include 2651, which would represent a 38.2% retracement of the correction from February 19 to March 23, along with 2793, or 50% retracement, and 2935, which represents 61.8% retracement. In addition, I am also watching the 400-day moving average at 2903 and falling as well as the 200-day moving average at 3024 and falling. As the S&P 500 Index approaches any and all of these five key technical levels, I will be watching to see how the market responds and whether stocks are showing signs of failing at resistance or breaking further through to the upside.
If we reach any of these key resistance levels between now and next Thursday, investors should carefully consider whether they want to use this bounce opportunity to exit before things really start to pick up in April. This is precisely what I will be doing in the week ahead with an eye toward reducing risk.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Global Macro Research makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.
After years of policy stimulus, stocks are now falling from record high valuations and bond yields are at historic lows. Reality is now returning to global capital markets. Do you have a plan to navigate what is left of today’s bull market while also positioning for the next bear market?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: I am long selected individual stocks as part of a broad asset allocation strategy.