Stocks continued to rally as confidence builds that the reopening process is going well from an economic point of view. At the same time some bond yields remain depressed. Most likely this reflects active high volume buying by the Federal Reserve, more than investor concern that the state of the economy will remain depressed for an extended period of time.
It is very hard for investors to piece together an economy in apparent shambles and a stock market that keeps going up. Even accepting the benefit of a continued flood of money coming in from the Federal Reserve, it is hard to accept that everything is so rosy. Look at the graph below.
This is a picture of the Fed’s balance sheet. The sharp inflection, representing an acceleration of money into the economy, began in late February. It gets updated every Wednesday. Through last week there were few signs that the acceleration was slowing. Between February and mid-March, the positive thrust of the Fed’s actions was overwhelmed by the impact of market volatility, fear, and an enormous surge in computer-based trading. This is when the VIX went to 80+. But as markets calmed the impact became obvious.
Now look at the center grayish bar. That represents the Great Recession. Note that in the middle, around September-November 2008, the Fed took similar decisive action and the market responded. While stocks didn’t set a final low until March 2009, the double bottom of October and November 2008 was the culmination of most of the economic damage to the economy.
The Fed’s action to inject liquidity into the market calms markets. Ultimately, it breaks the fear that forces businesses and individuals to freeze in place and slows the velocity of money toward zero. As calm is restored, so is economic order. Obviously, the economy restarts from a lower level. It took years for the economy to recover from the 2007-2009 recession but the stock market never looked back after March 2009, except for a brief wiggle during the European debt crisis in 2010-2011. In fact, the first down year, 2018, happened as the Fed was reducing the size of its balance sheet.
In 2008, in very quick fashion, the Fed doubled the size of its balance sheet from $1 trillion to $2 trillion. By 2015, as monetary easing continued, it rose to $4 trillion. Now another crisis has sent it soaring again to over $7 trillion, and there are no signs of ending yet.
Recessions reduce capacity utilization rates. Today, the rate is in the mid-60% range. In the older days, anything over 80% represented a shift in pricing power to the sellers. Over 80% reflected tight supply and gave an upper hand to sellers. While there are spot shortages today, mostly Covid-19 related, there aren’t many any longer. Businesses will find, as they reopen, that it will require lower prices to sell unsold merchandise. One of the unintended consequences of easy money is that savers either need to save more to generate the same income, or they have less money to spend. Either way, it means the savings rate rises and capital spending falls. No need for additional capacity when capacity utilization is 65%. We were waiting for a capital spending boom before Covid-19 arrived, and we will be waiting a lot longer. Meanwhile, retirees will have less to spend unless they take more capital risk. Some are doing precisely that, another thrust for higher equity prices.
The May unemployment numbers will be released on Friday. Estimates run in the 15-20% range, a number not seen since the Great Depression. It is likely to be the low point of this cycle as most economies have now started to reopen. That’s obvious. What isn’t obvious is how far it will fall. That depends on the virus and legislation. Will Congress extend the $600 add-on to unemployment benefits when that runs out this summer? If it does, it could create a false incentive for some of those unemployed to take the summer off. In addition, while Covid-19 has finally been pushed off the front page of the newspapers, it hasn’t disappeared. Hospitalization rates in states that opened early, like Georgia, Tennessee, Texas, North Carolina, and especially Arizona, have turned up. They are not yet at levels that overwhelm hospitals, but if you believe that there won’t be a fall surge that could derail the economic recovery, you would want to see a continued slowing of the infection rate through the summer. So far, that isn’t happening. It’s still early.
The other issue investors wrestle with is whether the reopening resembles a V or a square root sign, a fast surge followed by a flattening at levels below previous peaks. There is evidence of both around the world in locations that reopened before the U.S. Thus, the jury is still out.
What we do know is that companies that reacted boldly and correctly have achieved far better results than those that barely moved at all. That is seen most dramatically as retailers reported results in May. Except for big box retailers selling necessities that remained open throughout the crisis, Covid-19 either served as an accelerant for major change or it froze companies in place. For instance, most Best Buy stores closed during the height of the pandemic, but they were still able to serve customers online and through curbside delivery. Target stores were largely open, but the company also benefited from a spike in curbside deliveries. While Macy’s also saw a rise in Internet customers, it was nowhere near as successful as Target and Best Buy. The former two have stocks flirting with all-time highs, and Macy’s continues to flirt with all-time lows as it struggles to survive. I could write the same tale for every industry out there.
What is happening in the stock market today is a bit of catchup. Many of the big leaders, notably in tech and healthcare, are churning in a sideways fashion although a few continue to surge higher. The momentum, however, at least for the moment, has shifted to stocks of companies that were more severely hampered by Covid-19, including the aforementioned retailers, banks, airlines, hotels, industrials, transportation and even cruise ship companies. The odds of complete failure seems to be dissipating. Airlines just might see the day of cash flow breakeven without going bankrupt. But that is far from a certainty, and the stocks remain more than 50% below old highs. Nonetheless, with the high-flying favorites at lofty valuations, this is the arena where investors are hunting for bargains today. Time will tell whether they are buying true bargains or value traps.
Today Rafael Nadal is 34. Anderson Cooper turns 53.
James M. Meyer, CFA 610-260-2220