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It's Just Math

By: Stephen Colavito Jr.
Chief Market Strategist, Lakeview Capital Partners, LLC

May 2020












Source: phsy.org

We think we know everything about Sars-CoV-2 and nothing about it. We can read every one of the (on average) 29,903 letters in its genome and know precisely how its 15 genes are transcribed into instructions to make which proteins. But we cannot figure out how it is spreading in enough detail to tell which parts of the lockdown of society are necessary and which are futile. Several months into the crisis, we are still groping through a fog of ignorance and making mistakes.

This ignorance is not surprising or shameful, but the natural state of things. Every new disease is different, and its epidemiology becomes clear only gradually and in retrospect. Is Covid-19 transmitted mainly by breath or by touching? Do children pass it on without getting sick? Why is it so much worse in Britain than Japan? Why are obese people, especially at risk? How many people have had it? Are ventilators useless after all? Why is it not exploding in India and Africa? Will there be a second wave? We do not begin to have answers to these questions.

Even the numbers are unclear on how many Americans have been infected or how many have died.  Exact numbers are hard to pin down.  As of May 15, 2020, the CDC (source www.cdc.gov) reported over 1.384 million cases and 83,947 deaths due to Covid-19.  So, the simple math would say that the mortality rate is close to six percent based on those numbers (the number of deaths divided by the number of cases reported).  But, simple math isn’t so simple because the denominator is wrong.  No one knows how many people have been infected because of the lack of testing.  What if the World Health Organization (WHO) is correct that up to 70% of people infected could be asymptomatic?  These individuals would never know they were infected and would go about their day as if nothing were wrong.  So the mortality rate is merely unknown.

It’s just math, but it’s flawed.















Source: CDC

Unintended Consequences

When the Federal and State governments put a “stay-in-place” order on Americans, the unintended consequence of that order is a massive amount of lay-offs and unemployment that has spread to every part of this country.  Payrolls declined by 20.5 million in April, the worst month of job loss in US history, according to the Bureau of Labor Statistics. The unemployment rate climbed to 14.7%, the highest since the Great Depression.  If you extend that number and extra week (5 in total), an additional 6 million lost their jobs, bringing the total to 26 million people.  All of the job gains over the last ten-years were wiped out in a matter of 5 weeks.  That math is ugly.

Unfortunately, even as States open back up, more job losses are expected.  The White House economic adviser Kevin Hassett expects the unemployment rate to climb past 20% due to the economic fallout from the pandemic and predicts that May or June will be the high point for job losses.  It is essential to understand this in historical context; in 1933, the unemployment rate hit 24.9%, the worst unemployment this country has ever seen.   We likely get very close to that number in the next month or two.

A Blind Eye

From my perspective, the market’s recovery over the last four weeks has been extraordinary.  There is no doubt in my mind that part of the rebound is central bank induced.  The Fed has manipulated and distorted both equity and bond markets beyond the bounds of the Federal Reserve Act.  They have acted like the Great and Powerful Oz, throwing fire and brimstone (aka; lots of money) almost every week into markets. 

They have not done all this with a blind eye from Washington.  No, Washington has been helping.  Special purpose vehicles (SPVs) have been established, enabling the Fed to buy assets and be financially backstopped by the printing press of the Treasury.  This makes all of the intervention done in 2008-2009 look like child’s play.  I doubt taxpayers understand the magnitude of this action.  Washington added as much debt in the last 27 days as it did in the first 192 years of its history. That’s big math and way beyond what I can count on my hands and toes.

As you view the chart on the following page, you can see just how quickly the Federal Reserve has added to their balance sheet. 












Source: St. Louis Fed - FRED

So, with markets going rebounding, the question I am often asked is, “what do you think?” The best way for me to answer this is to look at the markets in my nerdy kind of way.  Follow the math.

Bonds

 It’s interesting that Treasury bonds began to rally at the beginning of January, no doubt in anticipation of the Covid19 crisis, and it was more than six weeks before stocks peaked on February 19, 2020.  Some believe that Treasury bond forecasters are better prognosticators than equity mavens (this author included, but I was a fixed income trader and portfolio manager, so yes, I am biased).

So despite the rally in equities, bonds from the ten-year maturity and in have not moved.  The ten-year as of May 7, 2020, was paying 0.63% or a negative real yield of -1.37% (using the Fed’s estimate of CPI at 1.5%).  Go out thirty years, and you get a whopping 1.38% on your investment.

If the economy is going to get better as the equity market anticipates, why are bonds staying so low?












Source: St. Louis Fed - FRED

“All may be well.”

So said the King in Hamlet when he began to realize that forces were closing in to punish him for his evil deeds.  Similarly, equity investors in the last month have switched from fearing that Covid10 would cause a global economic nightmare, to believing that the economy will recover somewhat quickly.  So, which will be right, bonds or equities?

There’s hope for a cure or vaccine as Gilead Science’s stock jumped 10% on April 17, 2020, after a Chicago physician told colleagues that Gilead’s remdesivir, an anti-viral drug previously tested in Ebola patients, showed promising results for Covid19 patients in a clinical trial. All the more telling, this positive move happened, despite a Gilead spokeswoman who said, “Anecdotal reports while encouraging, do not provide the statistical power necessary to determine the safety and efficacy of remdesivir as a treatment for Covid19.” 

Meanwhile, Sanofi and GlaxoSmithKline are joining forces to develop a vaccine.  However, even if sone is found quickly, the public will be unable to use a vaccine until mid-2021, according to early reports from the FDA.

The financial markets also seem to hold great confidence that the massive monetary and fiscal stimulus will reverse the plunging economy.  As discussed, the Fed is throwing the kitchen sink, dishwasher, and refrigerator into the markets.  This stimulus, along with the PPP program, direct money to citizens and non-citizens alike, and Treasury pledges to cover billions in bad loans are all part of the helicopter money deployed to help revive the economy.  There is a “cause and effect” to all of this stimulus, but we will leave that for a future paper, perhaps one titled “Algebra.”

Equities generally front-run the economy.  Over my 25-years in the business, this average anticipation has been around  6-8 months.  But as I have run earnings numbers (which are incredibly difficult because most companies are not giving any forward guidance on earnings), the market seems to be looking 12-18 months in advance.  Bulls can make the argument that with interest rates virtually at zero, the higher multiples are justified.  They may prove correct, but I have always believed that “everything reverts to its mean.” So unless earnings show exponential growth, the math doesn’t seem to make sense.












Source: DYR.com

Rapid Recovery

Many investors believe that the economy will rebound quickly (bull case).  Of those that lost their jobs, most believe their unemployment is temporary.  The Wall Street Journal’s survey of economists sees the economy falling at a 25% annual rate in the second quarter but expects a recovery in the second half of the year with annualized growth rates of 6.2% and 6.6% in the third and fourth quarters, respectively.  For 2021, they foresee real GDP rising by 5.1%.  Again, this would explain the market jump as it looks 12-18 months ahead.

Indeed, if the economy can make that type of rebound, things will undoubtedly look better this time next year.  Based on what I have seen in the first three weeks since the State of Georgia lifted the “stay at home” order, I think those estimates may, unfortunately, be a bit high.  I also don’t believe companies will re-hire employees back as quickly as all have hoped for fear of a second wave or another order to stay-in-place.  I hope I am wrong.

In another sign of optimism, corporate insiders, executives, and directors bought well over $1 billion in company stock in March, according to Bloomberg.  The jump in net buying activity resulted from fewer insiders opting to sell while buying stepped up.

Beyond the Fed’s “pump up the volume” liquidity dump, many stock bulls believed that computer-driven trading algorithms also helped equities (see the S&P 500 chart below)

 












Source: Yahoo Finance

A Bull In A Bear Den

Those on the other side of the bull trade worry that all the monetary and fiscal stimuli here and abroad will create more demand than can be supplied, resulting in potential inflation.  Global production, they believe, will be curtailed by the inefficiency of re-establishing and shifting supply chains, restrained investment in cap-ex, and dilution of fiat currency with the trillions of dollars printed.

Should this play out, one would expect higher interest rates to curtail the economy’s inflation.  But that could cause another problem, the debt service coverage of an exploding federal deficit.  By the end of the year, the federal deficit is expected to be close to 26 trillion dollars, climbing over 3 trillion this year alone.  If the bears are right and inflation becomes a problem in 2021-2022, this could also be a budgetary issue for Washington.

Bears regard the recent stock surge as a bear market rally.  To begin, the 30%+ rise in the S&P 500 from 2,237 to 2,928 (as of May 8, 2020) offset only 56% of the previous 34% drop from 3,386.  A 50% rise after a 50% fall still leaves you 25% lower.

Furthermore, bear markets that accompany recessions last about 11 months, far longer than the recent one-month drop.  The US stock market has never reached a bottom in less than six months after falling over 30% in the face of a recession, according to Bank of America’s research team.

Both sides make good points. 












Source: Indian Express

“It’s Just Math”

The saying “It’s just math” has been a running joke (among others) with a friend of mine for the last two months.   But its really the truth. 

Yes, the old saying on Wall Street, “Don’t fight the Fed,” has held for the better part of the last ten years.  The Fed and other central banks have slashed short-term interest rates and directly added liquidity to capital markets (bye-bye price discovery).  The Treasury has done its part by printing money and increasing M1 (money supply) beyond anything this country has ever seen.

They do this in the hopes of increasing the velocity of money.  In essence, a strong economy has money exchanging hands (moving) at a rapid rate.  If you print dollars or add liquidity and that cash is being put in a cookie jar, it’s not helping the economy (see chart below).

 












Source: St. Louis Fed - FRED

As I review the Fed’s chart, the velocity of money (M2) continues to drop.  This chart is consistent among economies around the globe as central bankers are using the same playbook. The Japanification permeates globally (note: Japanification is a term used by economists to describe the country’s nearly 30-year battle against deflation and anemic growth, characterized by extraordinary yet ineffective monetary stimulus propelling bond yields lower even as debt burdens ballon – source Financial Times).  This isn’t my opinion; these are the facts as laid out by the Federal Reserves’ research.

This is my thesis of this paper.  If the math is flawed when it comes to Covid19, then I believe it is next to impossible for anyone in my position to have a high conviction in an economic outlook or market outlook currently (I have turned off CNBC).  The hope is that clarity comes sooner than later, but for now, it’s the best guess. 

So with that, as I look at the data, I would hesitate to believe a Fed led equity market can go in perpetuity.  So here is my best short-term “guess” as to how this plays out.

For Equities:

I believe Investors should be on the lookout for three specific aspects for equities.  The first and easiest would be for companies to clarify their earnings, so investors might know the true price/earnings ratio and determine if a stock (or market) is cheap or expensive.  Markets don’t like uncertainty, and if companies could give forward guidance on earnings, that would help.  Absent this, maybe the markets pause for 6-12 months and allow clarity or the depressed earnings to catch up to elevated levels.  Or lastly, the market corrects to price levels meeting the drop in the last quarterly earnings and economic regression.

In my opinion, those are the three scenarios that need to or are likely to happen to equities before I have confidence in this market.

For Bonds:

Central banks again penalize investors who have an absolute need for income, and I don’t believe this will change anytime soon.  Over the next 6-12 months, the 30-year Treasury could move to 2.00%, but I have a higher conviction that it stays below 1.75%.  Most, if not all, Treasury yield remains at a negative real yield against inflation.

For fixed-income investors, the challenge will be to find surrogates to invest in that can provide some yield without stretching too far in the risk spectrum.  Although utility shares have been weak lately, I like that asset class while staying away from REITs, which are likely to see a dramatic shift in office demand and possible bankruptcies, which may hurt that sector for the next 6-12 months.

Conclusion

For all of us, this is going to take a lot of time to play out despite the recent movement both down and up being swift and unprecedented.  This volatility may be the new norm as markets seek absolute truth to all the things (and others) discussed above, but there is no easy fix, and patience will be needed by investors and advisors alike.

I have always used math as an absolute because, generally speaking, it was.  But when the inputs into a formula are incorrect, then the math gets fuzzy.  Right now, the math is like Einstein drinking two bottles of wine and his theory of relativity coming up with M=EC cubed (note: not that Einstein enjoyed wine as I do, but his formula for mass-energy equivalence was E=MC squared).

Unlike many papers I have written, this one was difficult because I had to admit to myself I did not have the answers.  But I can sleep at night knowing that no one else does either.  So, for now, I am going to wait (like I am in a lot of other areas in my life) knowing that time will work things out in one way or another.

For citizens working, teaching children, etc. from home, we are learning patience. Our lives are not normal right now.  Investors would be wise to think of the market in the same context.  When 2 + 2 = 15, we know that the math isn’t right, and patience will be required during these crazy times.

I wish you and your family health and safety.  Please call us at LCP if you have any questions, we are here to help.