Stocks soared on Friday after a surprisingly good May unemployment report. Who would have thought that one could describe a 13.3% unemployment rate as good, but an even higher number was expected. Actually, if you read the weekly cumulative unemployment claims instead of simply adding up the weekly totals of new claims filed, you would have come to a number fairly close to the 13.3% figure that was reported.
The most asked question that I hear constantly is “How can the market keep going up during an economy this bad?” Let me lay out some answers and then go into greater detail.
1. The economy is getting better, not worse. As bad as it is, tomorrow looks brighter than today.
2. Interest rates remain close to record low levels. Stocks are not priced in a vacuum. They compete with other financial assets. When you can’t get 1% for ten years buying U.S. Treasuries, stocks look more appealing.
3. The Fed keeps pumping money into the economy. Whatever isn’t immediately put to work is invested. Don’t fight the Fed.
4. Fears of just a month ago were probably exaggerated. It wasn’t that long ago that pundits suggested Disney World couldn’t reopen this year. Ditto for Las Vegas. Vegas is now open and Disney World is getting set to reopen.
5. Covid-19, at the moment, seems less threatening than it did in mid-April.
All this explains why stocks have moved up from their March lows. But implicit in the earlier question is can this rally keep going? After all, stocks have recovered virtually all their February-April losses at a time when economic activity, whether you measure it by GDP, profits, or employment, is still well below levels anywhere near where they were in January. While a few talk of a possible V-shaped recovery, most believe, as I do, that after an initial surge, moving higher is going to be a slow slog.
I will use the employment picture to back up my point. There are a few sectors that catching up with demand could mean record employment levels. Construction comes to mind. The U.S. housing inventory is depleted and, for a myriad of reasons, there is likely to be an acceleration of the movement already in place to go from urban centers to the suburbs. But that is an exception. About 2/3 of the surge in employment in May was from restaurants reopening. That will continue for another month or two as other states start to allow restaurants to reopen. But restaurant volumes are unlikely to match what they were before Covid-19 for a very long time. Those at risk for catching the disease are not likely to go to a restaurant very often. Group events will be down. As millennials move to suburbs and build families, they will eat dinner out less. The same applies to retail. The movement toward online shopping will slow in-store sales further. State and local governments face massive budget imbalances due to expected revenue shortfalls. Education will be a significant victim. Communities are going to have to learn how to integrate technology more and save on labor. That means fewer teachers. Online learning alone isn’t working, but just as omnichannel retailing has been a big success, omnichannel education is inevitable. I could keep going on but you get the point. Today there are a bit over 20 million unemployed. Before Covid-19, that number was closer to 5 million. Some have estimated that about 8 million permanent jobs could be lost, about the same number that were lost in the Great Recession. That guess may not be precisely right, but it is probably in the ballpark. Thus, by year end, well over 10 million Americans are still likely to be unemployed.
Amid the surge in the stock market this week, you might not have noticed the rise in bond yields. That makes sense. The Fed is still buying bonds, but over the past two weeks the net increase in its balance sheet has been about $60 billion per week, well below levels of just a few weeks ago. Markets clearly need less help. But that is still adding at an annual rate of $3 trillion, hardly chump change. When the Fed was adding nothing at all, the 10-year Treasury traded at yields of 1.5-3.0%. Friday they were around 0.9%. Part of that is Fed buying. Part of that is lower inflation expectations. But inflation may be starting to rise as well. If you want to buy gasoline under $2 per gallon, do it soon. Oil, which was below $10 per barrel is back around $40. Expecting a great deal when car dealers reopen? Think again. Their inventory was depleted by online sales and car plants are just getting cranked up again. Home prices may not rise in urban centers but there are bidding wars erupting in the suburbs. Mortgage rates and rents are probably at their lows. A month ago, there were whiffs of deflation in the air. No longer. Although no one I read is predicting 10-year bond yields to return to anything close to 2% anytime soon, I ask why not? If you accept the argument that the virus has a finite life and will pass at some point, then you accept a gradual return to normality including the cost of money.
As for the virus, I have no intention of stepping out of my league and trying to make any predictions of its path. Extended daylight, more outdoor activities, and fewer people locked in schools should contain the spread this summer. But I think a key that may have been ignored by those forecasting pending disaster is that caregivers have learned constantly how to do a better job. As a result, the death rate is declining rapidly. That should not only be a source of comfort, it should help preventing our health care system from being overwhelmed should a fall surge occur. Remember, financial markets don’t have a conscience. They care about dollars and cents, not about how many people get sick. If the economy stays active amid a surge, the disease will become less relevant to financial markets.
Now I want to look at the stock market itself. There have been three waves to date. The first had a very distinct beginning as stocks fell from all-time highs in February to their lows in late March. That was a time of overwhelming fear. No one could see the light at the end of the tunnel. We didn’t even know then if quarantining in place would work. But as early signs of success in places like China and South Korea gave hope, and the Fed moved massively to unfreeze the fixed income markets, investors began to take more risk. They started by buying stocks of companies that were either immune to the impact of the virus or the few that actually benefited, from Zoom to Clorox. But investors still wanted no part of those businesses where actual survival was threatened. This was the second wave.
Gradually, the disparity in values between those without any warts and those that clearly were damaged goods in a world shut down became so great that bargain hunting began. People started to nibble at oil companies and banks. This past week, nibbling turned into a feeding frenzy. American Airlines went up over 40% in one day. Welcome to the third wave.
But we have to keep perspective. It is great that airline bookings are up 350% from their April lows, but they are still down 85% from last year. Flights are now half full again, but with far fewer planes in the air. To survive, airlines have added mountains of additional debt. They need to get almost all the way back to last year’s bookings to justify today’s stock prices. That could take years. OpenTable notes that restaurant reservations, including walk-ins, are still down 80%. That number will come down as more states reopen, but it is going to be a long climb to get back to where they were or what’s needed to become profitable again. If you can remember back to 2009, there were many empty storefronts as we came out of recession. I suspect the picture three months from now will look very similar, a combination of small businesses and broken larger companies (e.g. JC Penney) that couldn’t make it.
Thus, I think, looking forward there is justification after Friday’s rally to take pause and ask how much more is left. Clearly, if rates stay ultra-low and central banks keep expanding balance sheets, some tailwind remains. But if you didn’t buy Delta Airlines at $20 two weeks ago, why would you want to buy it at $35 today? Chasing a rally can be just as dangerous as panic selling near the bottom. Instead, look at every stock you own and decide whether to buy, hold or sell on its own merits. Jim Cramer always says, “Bulls make money, bears make money, but pigs get slaughtered”. There is nothing wrong holding a little extra cash.
At the same time, there is no rational reason to sell massive amounts of stock here either. When the market declined 35% in five weeks, there was a clear economic reason. Virtually no one expected in mid-February what was about to happen economically in less than a month. Today, we can’t say the same. Markets are reopening in a measured and logical way. There are not a lot of surprises. Golf courses are fully booked. People will take vacations this summer, not everyone, but most. Those of us locked out of our businesses will be returning soon, albeit with masks and Purell in hand. Thus, if equity investors have overreacted, a mid-course correction is possible. But the actual facts probably won’t change all that much over the coming months, suggesting a correction, if it occurs, should be moderate. We will have to see whether the virus flares or not in the fall (all my doctor friends say it will), and both vaccines and effective therapeutics matter for the psyches of those most at risk. But even then, we have a pretty good idea that there will be a vaccine broadly available about a year from now, maybe a bit sooner. Therefore, the ingredients for a sharp correction simply aren’t obvious at the moment. For one to happen, there needs to be a decisive shift in economic fundamentals akin to the impact of quarantining in place during March and April. Similarly, I don’t expect a repeat of Friday’s surge any time soon. Rather I expect a choppy market moving with the ebbs and flows of a recovery that faces some speed bumps along the way. To me the biggest risk is not the virus, but a spike in interest rates. That’s not a prediction, but it is my biggest concern.
Today, Kanye West is 43. Nancy Sinatra turns 80.
James M. Meyer, CFA 610-260-2220