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)

In April, we witnessed the May WTI Crude oil contract move into significant negative territory as storage filled up and speculators were aggressive at rolling over contracts before expiration.
South Korea’s exports dropped 24%, nearing that of the global financial crisis.
Based on analysis by Stifel, the S&P may be range bound through the decade.
84% of US small firms are paying less than 50% of rent due in May, and 40% are skipping rent altogether this month (based on a survey from Alignable). With lockdowns in some parts of the US just starting to abate, it’s possible this trend continues into the summer.
Missing rent is going to generate tremendous losses for commercial real estate firms.
Not a surprise that the Fed’s balance sheet has exploded and is likely to keep increasing as they continue purchasing assets. Some estimates show their balance sheeting $10 Trillion in the very near future.
Fed’s balance sheet is well above World War II levels and is likely going much much higher.
Going back to 1949, if GDP estimates prove accurate, 2020 will be the worst drop in GDP.
It’s going to be a very ugly earnings season. So far every quarter is predicted to have negative earnings through the rest of 2020.
It took 2 months to wipe out all job gains following the global financial crisis. What an astonishing thing to have happened in only 2 months time.
Long term forecasts tend to be more accurate than shorter ones as is indicated by the clustering in the top chart. Based on current forward PE levels in the S&P, this chart shows 10 year forward returns are predicted to be 0.
The S&P 500 is getting more and more concentrated. Currently, the top 5 stocks account for just over 20% of the index, higher than the dot-com peak of 18.1%.
I’ve referenced this concept a lot over the previous few months. Valuations don’t matter until they do and while they don’t seem to matter currently, at some point mean reversion occurs.
As you likely already knew, Q2 GDP is going to be rrreeeeeaaallllyyy bad.
One good piece of news is that companies have refinanced and leverage loan maturities don’t hit the wall until 2024. That gives us 3-4 more years to prepare for this.
And by zombie company, we mean any company whose profits fail to cover its debt servicing costs. The survival gap is filled with chronic borrowing. According to research firm Axios, nearly 20% of US companies can now be counted among the living dead.
The forecast shown in the next chart for the travel and tourism industry is a major component in the bleak condition of state finances. Travel related businesses add measurably to state and local tax revenue. With current projections for travel demand to remain subdued for another three years, budget battles, furloughs, and cutbacks will be the norm for the foreseeable future.
Good to understand where Biden stands and how it could impact our economy and taxes if elected.

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 CapitalSteve Blumenthal’s On My Radar

Proper Wealth Management’s (“Proper”) blog is not an offering for any investment. It represents only the opinions of Jared Toren and Proper . Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest. Jared Toren is the CEO of Proper, a Texas based Registered Investment Advisor.   All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Information contained herein is believed to be accurate, but cannot be guaranteed. This material is based on information that is considered to be reliable, but Proper and its related entities make this information available on an “as is” basis and make no warranties, express or implied regarding the accuracy or completeness of the information contained herein, for any particular purpose. Proper will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this newsletter caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this newsletter.  Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The material contained herein is subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Proper may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. Proper Wealth Management is not responsible for any errors or omissions or for results obtained from the use of this information. Nothing contained in this material is intended to constitute legal, tax, securities, financial or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this material should not be acted upon without obtaining specific legal, tax or investment advice from a licensed professional.

Author: Jared Toren

Jared Toren is CEO and Founder at Proper Wealth Management. Proper was born out of frustration with the inherent conflicts of interest at big brokerage firms influencing advisors to sell products that were not suitable for clients but profitable to the firm along with a consistently mixed message of who’s interest was supposed to be put first; the clients’, the firms’, shareholders or advisors. At Proper, our clients interests come first. We are compensated the same regardless of which investments we utilize so there’s no incentive for us to sell high commission products. Since we focus on a small number of clients, we are able to truly tailor our advice to each person’s unique circumstances.