1) The May jobs “shocker” was largely a reflection of CARES coverage of corporate payrolls.
2) The gap between Wall Street and Main Street appears similar to the “incubation phase” of other major downturns.
3) Federal support remains essential, but is best targeted toward preserving the “circular flow” of the economy by supporting the basic incomes of families and incentives for productive investment, limited to those actually experiencing economic damage.
4) After years of overborrowing to finance stock repurchases (partly to offset dilution from stock-based compensation), many corporations were overleveraged coming into this crisis. Bankruptcies are likely to increase, but the government can support packaged restructurings and bank purchase-and-assumption transactions without bailing out private investors, who agree to accept these risks in a free-enterprise system.
5) Fed “leverage” of CARES funds to purchase uncollateralized corporate bonds violates FRA 13(3), CARES 4003(c)(3)(B), and potentially Article 1 Section 8 of the U.S. Constitution.
6) Projects that are enabled only by zero interest rates are most likely projects that are speculative and unproductive.
7) Improved market internals currently encourage an agnostic near-term outlook (though not a bullish one) despite several features that suggest the improvement is fragile.
8) Valuations are again near historic extremes.
9) Continued dispersion within the U.S. equity market suggests particular risk for richly valued large-cap stocks.
On Friday June 5, the Bureau of Labor Statistics reported that U.S. nonfarm payrolls jumped by 2.5 million in May, following a (downwardly revised) loss of 19.7 million jobs in April, sending Wall Street on a full-tilt, dubstep remix of “Happy days are here again.” It was a fitting choice, given that the song was written in 1929. Of course, the Great Depression also began with a spectacular financial rebound that bore no relationship to the underlying deterioration on Main Street.
Severe economic recessions often feature what might be called an “incubation phase,” where an exuberant rebound from initial stock market losses becomes detached from the quiet underlying deterioration of economic fundamentals and corporate balance sheets. From the post-crash low of November 13, 1929, the Dow Jones Industrial Average enjoyed a 48% rebound, peaking on April 17, 1930, followed by an 86% collapse by July 8, 1932 (an overall loss of 89% from the September 3, 1929 bull market peak).
To understand the apparent jobs report “shocker,” a bit of arithmetic may be useful. As part of the $3 trillion CARES economic bailout package, the “Paycheck Protection Program” (PPP) provides $349 billion to small businesses, which can cover payroll costs for up to 24 weeks, and is payable regardless of whether employees are actually working or not – so long as they are kept on the payroll. Now, median personal income in for U.S. workers is about $34,000 a year, and 24 weeks amounts to $15,700. So $349 billion of PPP funds essentially covers the paychecks – temporarily – of over 22 million U.S. workers.
In the Household Survey, which is used to calculate the unemployment rate, the Labor Department admitted that survey takers mistakenly counted 4.9 million furloughed workers as employed, but did not correct the data, ostensibly “to avoid the appearance of political manipulation.” Accordingly, the reported unemployment rate was 13.3% for the month of May. The corrected data would show a 16.1% unemployment rate.
Even that figure does not reflect the 4.7 million workers who have abruptly dropped out of the civilian labor force since March, and are not included because they are not presently looking for work. To gauge this impact, note that the ratio of May civilian employment (corrected for miscounts) to the March civilian labor force is 0.812. So even if every single worker currently counted as “employed” would still retain that status without PPP or other CARES funds covering their paycheck, a plausible estimate of the U.S. unemployment rate would still be about 18.8%.
A New York Times analysis noted that if one includes marginally attached U-6 workers, those working part-time but looking full-time work, and those reporting they want a job but are not currently looking, the unemployment rate would be 27.0% here. However, that figure can’t be directly compared with the headline number, which never includes these categories.
Still, Wall Street was shocked and exuberant that reported employment bounced back by 2.5 million, evidently not giving a moment’s thought of what has financed this rebound, nor the fact that this support is impermanent. What we are observing is not “recovery,” it’s the impact of a government program that is paying the salaries of employees that are kept on payroll, whether they are actually working or not.
One thing that Wall Street does have going for it, however, is that to the extent that companies are still generating revenues, and are paying workers with PPP funds from the government, some portion of the $349 billion in PPP funds actually represents a pure subsidy to profit. That’s because forgiveness of these loans is not conditional on whether companies have actually suffered economic damage.
While the PPP program is targeted toward small businesses, some portion of the $500 billion slush fund provided to the U.S. Treasury for states, municipalities, and businesses is also likely to feed into profit subsidies – though not enough to offset overall weakness in U.S. corporate earnings.
Many civic-minded members of Congress were distressed at how insistent some legislators were to avoid oversight that could prevent the misuse of public funds. For a discussion of how future policies can better ensure that economic support goes to families and businesses that have been negatively affected, rather than subsidizing corporate profits, extraordinary compensation, and private investment losses, see the economic policy section of last month’s market comment.
Severe economic recessions often feature what might be called an “incubation phase,” where an exuberant rebound from initial stock market losses becomes detached from the quiet underlying deterioration of economic fundamentals and corporate balance sheets.
Part of the current enthusiasm of investors seems to be the idea that the stock market typically reaches its low before the economy does (though this was certainly not true of the 2001 recession). On the idea that the second quarter of 2020 will be the low point for the economy, there is a superficial sensibility in “looking over the valley.” The problem is that post-recession bull markets typically begin at valuations about 40% of those we observe at present.
Investors make the same mistake when they observe that the stock market essentially went nowhere between 1918 and 1920 despite the Spanish Flu pandemic, and then launched into a bull market that extended for nearly a decade. What this argument fails to observe is that market valuations between 1918 and 1920 stood at less than a quarter of current levels, representing the most steeply undervalued period in U.S. history. So yes, if the U.S. stock market loses three-quarters of its value from current levels, I expect that stocks would become fairly resilient in response to additional negative developments, and would likely enjoy an extended bull market from those levels.
Gradually, then suddenly
It’s sometimes said that “risk happens fast.” Yet underlying financial damage often has a long and quiet incubation phase, which is why Hemingway, in The Sun Also Rises, described bankruptcy as occurring “gradually and then suddenly.”
The current “incubation phase” is reminiscent of 2008. Early that year, AIG admitted that it could not “reliably quantify” its losses. In March, Bear Stearns failed. The Associated Press published an article discussing the unprecedented interventions by the Federal Reserve, including Bernanke’s creation of “Maiden Lane” shell companies to absorb bad mortgage-backed debt (which at least represented collateralized debt, unlike the uncollateralized corporate debt the Fed is illegally purchasing today). The article quoted Richard Fuld, the CEO of Lehman Brothers, who argued that this intervention, “from my perspective, takes the liquidity issue for the entire industry off the table.” Clearly, it did not remove the solvency issue.
After the failure of Bear Stearns, after strains in the subprime loan market were fully recognized, and after the Federal Reserve and the U.S. Treasury had already launched unprecedented interventions, the S&P 500 advanced in May 2008 to a level that was within 9% of its October 2007 peak, on the notion that all of the bad news had been “discounted.” The S&P 500 then lost 53% of its value.
The market reaction to the unemployment numbers today is our Bear Stearns ‘systemic risk is off the table’ moment.
– Ben Hunt, Epsilon Theory, June 5, 2020
The same sort of slow incubation characterized the financial markets in May 2001. An economic recession had already started two months earlier, and the S&P 500 had been in a bear market for over a year. But as the S&P 500 rebounded within 14% of the March 2000 bubble peak, the Wall Street Journal observed “Though economists are expecting this year to be the economy’s worst since 1991, only a tiny percentage think the economy is in a recession.” The S&P 500 would lose an additional 40% of its value by October 2002, and the technology-heavy Nasdaq 100 would lose an additional 60% of its value, bringing its overall bear market loss to 83%.
It’s sometimes said that ‘risk happens fast.’ Yet underlying financial damage often has a long and quiet incubation phase, which is why Hemingway described bankruptcy as occurring ‘gradually and then suddenly.’
In the face of a breathtaking disconnect between Main Street and Wall Street, largely based on overconfidence in free money, my sense is that there remains a crisis ahead that will emerge “gradually and then suddenly.” It is important to allow for that possibility, but nothing in our investment discipline relies on that outcome. It is enough to simply align our investment stance with prevailing, observable conditions – primarily valuations and market internals – and to shift our outlook as the evidence shifts.
Those of you who know me well know that I’ve had three mentors in my life; two of them, Jimmy Carter and my teacher Thich Nhat Hanh, who I’ve been blessed to call my friends; and Dr. King, who our nation rightly celebrates this week (and who, to close the circle, long ago nominated Thich Nhat Hanh for the Nobel Peace Prize). Among the many things they’ve all taught, and stood for, is that the person we might call our adversary is another human being, suffering in a way that we may not understand – perhaps from hatred, ignorance, fear, or perceptions of injustice – and that the only path to reconciliation is to encourage each to understand and address the suffering of the other. It’s always possible to do that in a way that is consistent with our own security.
My sense is that the peace of our world, and the civility of our nation, is at risk because people don’t really trust that idea. They’ve come to believe that an adversary is someone to be insulted, and attacked, and ultimately destroyed. That’s the behavior that they see modeled for them; encouraged to ignore our interconnectedness – that all of us are empty of a separate self, and full of causes and conditions that are common to our humanity. We become a stronger nation and a better world when each of us feels heard – and I don’t mean just when “we” feel heard and respected, but also when whomever we call “they” also feel heard and respected.
It’s often imagined that peace is the result of sufficiently crushing one’s opponent; of inflicting so much injury and suffering that they surrender. There’s little doubt that conflicts can be ended in this way, but only at terrific cost, and with deep scars that feed later hatreds and conflicts. Others somehow come to imagine that waging peace requires one to lay down defenseless. It’s just not so. Peace doesn’t mean that one doesn’t defend oneself, or refrain from criticism. Peace doesn’t demand the absence of strength. It asks each side to see and understand the suffering of the other, whether that suffering is rooted in reality or misperception. It asks us to refrain from needlessly provoking the adversary, or to insult them in order to boost our pride. It asks us to look to address their suffering in ways that are consistent with our own security. If peace demands anything from us, it is to refrain from being infected by hatred. Dr. King recognized that:
“Darkness cannot drive out darkness; only light can do that. Hate cannot drive out hate; only love can do that. I have decided to stick with love. Hate is too great a burden to bear.”