The Economy

Economic indicators have worsened markedly. There is no question that, at best, the long-predicted recession is upon us. Unemployment is now 13.3%, reflecting 21 million people looking for work. This is about the same number as during the Great Depression, although the rate was a much higher 25% then. Likewise, the current labor force participation rate is at the lowest level since 1974. Economists are predicting that the GDP-measured business activity will have contracted 35% when the results for the second quarter are tallied.

As might be expected, consumers are retrenching as well. The index of their (yours and my) sentiment has also dropped markedly to a level that is consistent with the level of feelings often encountered at the beginning of a recession. In the past, it has taken anywhere from 4 to 7 years from there to return to a point of comfort.

Businesses are retrenching along with their customers. The ISM manufacturing and non-manufacturing activity indexes (which imply a contraction when readings are below 50) are currently sitting at 43.1 and 45.4 respectively. One bright spot is that the homebuilder sentiment index has rebounded to 58 (also with a reference point of 50) from 30 in April. Likewise, single-family home prices have held up, actually gaining 1.5% nationally vs. a year ago, although the volume of existing homes sold dropped by 31% during May.

There have been a number of commentators suggesting an alphabet of economic predictions. Will the recovery be “V" shaped and recover as quickly as it has dropped, “U” shaped and recover more slowly, or “L" shaped and not recover at all in the foreseeable future? They talk, but do not know.

It is fairly safe to say that Covid is a short-to-intermediate term event (hopefully), and it is likely that the length of the recession will depend on how soon the infection level becomes acceptably low. The longer people are restrained from normal activity, by decree or otherwise, the more businesses will fail. The more businesses that fail, the longer it will be until we can resume normality again. The government's support programs are designed to keep business structures in place, so that they will survive and not need to be re-established at the end, thereby speeding the eventual recovery.

Of course, we will never have the exact same normality. That can be good news in this process. As an example of Joseph Schumpeter's concept of “Creative Destruction", weaker businesses and older less productive methods can be replaced by newer business and more effective methods, refreshing healthy economic growth. To the extent that government bailouts short-circuit this process, less renewal will occur at the expense of long-term health. Academically, it is a difficult trade-off. Most people, especially politicians standing for re-election, will choose the quick short-term recovery.

 

The Markets

If you throw a rock in a pond, as the rock hits the surface and then sinks, the water surface shows outgoing waves, eventually diminishing in size. So is it with a financial shock. The stock market rock hit the economic pond in early March. It continued to sink through March, generating the first ripples, but not necessarily pointing to a new trend. Right now, the financial markets are reacting, largely divorced from economic reality. They were hit by the Covid rock, but were then supported massively as the Federal Reserve seeks to ensure that the health and economic crisis does not turn into a financial crisis.

The government’s intent is to smooth out the ripples, using their (almost) infinite supply of capital to intervene in markets, set interest rates, support stock prices as well as support the economy. There are two major factors that influence stock market prices – the economy and company earnings, and the availability of money (also known as liquidity). The Federal Reserve has a great deal of influence on the liquidity factor. Since the end of the last recession, the Fed has been supporting the market and the economy by creating liquidity, which reduces interest rates and raises stock and bond prices. In 2008, the assets on their books were less than $900 billion. At the end of that recession, their Herculean efforts created another $1.4 trillion, and they have been pumping more into the economy ever since, even though there had been no further recession, and there was record low unemployment. The Fed’s assets reached a peak of $4.4 trillion in 2015. New efforts, as a result of Covid, have brought the current level to over $7 trillion, which is 7 times more than the level 10 years before.

The financial markets have become ever more reliant on the induced liquidity. Earnings, the historical driver, have become less important, causing market values in relation to earnings to become unsynchronized and to soar back to levels that are well above the 1930s and approach the dot.com bubble peak of 2000. The emerging dependency is also seen in short-term crashes like the 10% drop in “safe" 10-year treasury bonds in the 2013 Taper Tantrum, the 14% mini-bear market of 2015, and the recent 20% crash in 2018. The scenario is that the Fed announces that they are planning to reduce accommodation, or in the case of 2015, it merely levels off. The problem lasts until they announce that they were just kidding and reverse course.

The markets (and public) have become used to the central banks backstopping their portfolios and creating non-stop bull markets. This can be fine and build confidence while it occurs. The problem is that it may not be able to last.  The market dependency creates systemic risk affecting all involved. Schumpeter would see the results of their policy as allowing risk and weakness to remain in the system. Market traders recognize that the risk is real, but are willing to trade any way. Our concern is that the general investing public does not understand the severity of the overvaluation that has been created, and the 401(k) balance they see every month may not be real, in the sense that it is at risk, not supported by a continuing economic reality.

It may be comforting to know that since 1998 there has been an entity called the president’s “Working Group on Financial Markets” made up of representatives of the Treasury, Fed, SEC and others. The Washington Post dubbed this group the “plunge protection team”, which is thought to influence financial institutions to intervene in the event of a large market sell- off. My expectation is that the government may have played a role in the rapid reversal of the stock market decline in April. This intervention adds stability to the markets, but when investors rely on this protection, perhaps without even knowing it, their real risk exposure can be greatly underestimated.

Here’s a scenario to consider (not a prediction) that is a synthesis of these factors. If the stock market is overvalued by 70-150% as long-term valuation currently suggests, a short-term drop of 40-60% could theoretically be the remedy. Alternatively, if the economy grows at a 5% rate (including inflation), then a zero market return would return to normal value in about 8-12 years. We might assume that the currently aggressive Fed policies and plunge protection would not allow a 40-60% decline, especially in an election year (although years following an election may be a different story). In light of the Covid earnings slow down, what if the market insists on returning to a normal level? Might the Fed decide to drive policy toward the flatter outcome for the next 8-12 years by intervening to abort declines? To implement this approach, it would take the plunge team time to react when a sell off begins, so what would we get? Would it be a flattish, low-growth market interrupted by periods of high volatility?  This is just a thought, but a scenario to consider when you are doing your personal financial planning.

It is these types of conditions that may warrant reconsideration of your financial plans, if they are based on a repeat of average historical returns and/or a buy-and-hold investment strategy. What has worked in the past may need to change in the future. We suggest creating or updating your plan once the current conditions stabilize. LFM&P is ready to help when you are.