Who would have saw that coming? After experiencing a sudden and significant drop in March as the reality of COVID-19 set it, the S&P 500 logged a ~20% gain in Q2. Given that we’re no way near out of the woods and economists are expecting defaults to surge (further), a lot of folks are asking (me) how long our markets will stay detached from economic reality. The Fed has certainly come to the rescue of the markets and have seem to put a floor under prices in many market segments such as stocks and high yield bonds.
We treat the Fed like they’re the firefighters when they’re actually the arsonists
As Jean de La Fontaine said, “We often meet our destiny on the road we take to avoid it”. Similarly, the Fed’s attempt to prevent recessions and suppress the business cycle will invariably lead to a much bigger recession in the future. Or as Nassim Nicholas Taleb would say, our attempt to make our system antifragile will lead to greater fragility. We’ve just witnessed the fastest and greatest balance sheet expansion in our history and the Fed is not close to being done. The Fed expanded its purchases to high yield debt and I wonder if stocks are next during the next shock.
Our corporations, which were heavily indebted prior to COVID-19, are now indebted further as corporate bond sales ballooned the past few months as the Fed put came roaring back. Companies strong enough to gain access to the bond markets have borrowed $1 trillion this year at the fastest pace on record. Then there are those that can’t afford to carry the debt they have, leading to the most large bankruptcy filings in the first five months of the year since 2009, during the Great Recession. The number of zombie companies (companies who’s profits don’t cover the interest on their outstanding debt) is no doubt going to rise.
Our large cap stock indices have been incredibly resilient in the face of a huge drop in earnings/GDP amid a highly uncertain backdrop. Without the Fed hitting <Ctrl + P>, we’d likely be in an environment of higher volatility and lower stock prices. With markets having levitated to essentially be flat on the year, the risks to the downside still persist.
To highlight a recent GMO quarterly letter,
“There are no certainties here. At GMO we dealt with three major events prior to this crisis, and rightly or wrongly, we felt “nearly certain” that sooner or later we would be right. We exited Japan 100% in 1987 at 45x and watched it go to 65x (for a second, bigger than the U.S.) before a downward readjustment of 30 years and counting. In early 1998 we fought the Tech bubble from 21x (equal to the previous record high in 1929) to 35x before a 50% decline, losing many clients and then regaining even more on the round trip. In 2007 we led our clients relatively painlessly through the housing bust. In all three we felt we were nearly certain to be right. Japan, the Tech bubbles, and 1929, which sadly I missed, were not new types of events. They were merely extreme cases akin to South Sea Bubble investor euphoria and madness. The 2008 event also was easier if you focused on the U.S. housing euphoria, which was a 3-sigma, 100-year event or, simply, unique. We calculated that a return trip to the old price trend and a typical overrun in those extreme house prices would remove $10 trillion of perceived wealth from U.S. consumers and guarantee the worst recession for decades…”
..”Everyone can see and feel that this is different and can sense the bizarre nature of the market response: we are in the top 10% of historical price earnings ratio for the S&P on prior earnings and simultaneously are in the worst 10% of economic situations, arguably even the worst 1%!”
Charts, Commentary & Perspectives
(In no particular order)
I hope you enjoyed this months financial markets update. If you have any questions please contact us directly. If you’re interested in a topic that you’d like us to address, please email us so we can include them in future updates.
If you’re interested in starting a dialogue and learning how we can help, please contact us.
Best Regards,
Jared Toren
CEO & Founder
Sources: Edges & Odds, WSJ Daily Shot, 361 Capital, Steve Blumenthal’s On My Radar
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