The Coronavirus Rally? It's a Fugazi.
This is the third blog post in my series on the coronavirus and the related market impacts.
I've been asked by clients and friends what to make of last week’s rallyin the stock markets.
What I make of it is simple: itshould be sold.
If you failed to get out of risk assets during the selloff that startedon February 24th, you have a great opportunity to sell now.
This rally is a fugazi, straight out of the bear market playbook and it should be sold now, with no delay.
Don't believe me? Riddle methis: can you name one 10-plus percent daily stock market rally that occurredin a bull market? You can't, because ithas never happened. How about a 20percent three-day move? Same.
Violent equity rips only exist in bear markets. I can remember multiple 10-plus percentrallies in the NASDAQ during the bursting of the tech bubble. Every one of them presented a great sellingopportunity during the NASDAQs epic 78 percent decline.
Chart 1: NASDAQ Rallies During the Tech Bubble Bursting
As can be seen in Chart 1, above, the NASDAQ experienced seven ralliesof 13 percent or more during it’s nearly three-year decline. Three of those were over 45 percent.
Many pundits and White House sycophants seem to believe this wholecoronavirus distraction is just a one-quarter “blip” in the evergreen bullmarket/economic expansion, and everything will be back to normal in a month.
If that was the case, wouldn’t oil be rallying off the lowest pricessince February 2001? Likewise, wouldn’t10-year U.S. Treasury yields be rising from the lowest levels in history? They would, but they are not.
Chart 2: S&P 500 v. Oil and Bond Yields - 2020
Oil and bonds are putting the lie to this stock market rally.
1987 and 2018 Playbooks
Investors seem to be looking back to October 1987 or December 2018 inorder to justify buying equities. In1987, there was a sharp four-day sell-off that culminated with “Black Monday”,when the S&P 500 closed down more that 20 percent. The difference is that the 1987 Crash wasprecipitated by the Fed raising interest rates and then perpetuated by crude“portfolio insurance” algorithms, which sold more shares as the marketdeclined, creating a never-ending wave of selling.
The declines were man-made and thus easily reversed.
Likewise, in December 2018 the market sold off because the FederalReserve were raising interest rates and reducing balance sheet.
The market sold off until the Fed reversed on interest rates and thenbegan stealth quantitative easing operations via repo lines with U.S. banks.
Again, it worked because the decline was Fed induced, therefore the Fedhad the power to reverse it.
Needless to say, the current decline was not Fed induced.
Chart 3: SPX v. Oil and Bond Yields – 2018
In 2018 oil rallied with stocks and bonds steadied their decline. That has not happened this time. Oil is still collapsing and could go under$10/barrel. Indeed, some producers arepaying others to take oil from them.
Bond yields continue their march towards zero, signaling a deep recessionor depression.
Investors may also be buying stocks based on the record $2 trillion infiscal stimulus that will soon hit the U.S. economy.
The only problem with that is there is no stimulus in it.
A single person will get a $1,200 check from the newly-convertedsocialist Donald J. Trump around April 8th.
Not one dime of it will stimulate the economy.
Why? The average rent for U.S.one-bedroom apartments is $1,078. The remaining $122 dollars will buy about aweek’s worth of groceries.
These are expenses that would have been paid anyway.
In order to stimulate the economy, those funds would have to go towardsdiscretionary items that normally would not have been purchased. Examples of those include: a new computer, washer/dryer, or a vacation. No one depending on a stimulus check will bebuying such durable/discretionary goodsfor quite a while.
The same is true for corporations in line for government cheese.
Don't misinterpret me, I am not against the efforts to support individuals (the corporate welfare queens who have levered up for the past 11 years are another story) I only want to point out that these transfers are not going to kick-start the economy.
At best, they will support some of the unemployed people who mostlikely have no savings.
I read a lot of happy talk about a "V-shaped recovery".
Really? We're going to get 20-30percent unemployment and then everything is going to go back to normal withthree percent unemployment in the third quarter?
Even if the coronavirus were to magically disappear right now, therehas been deep and long-lasting damage to the global economy.
I don't think anyone has really understood how debilitating this is,and will continue to be, to the national and global psyche.
Consider the cessation of all professional and amateur sports.
This alone is a traumatic blow to the global spirit. The lack of sports has removed a great joyfrom the world.
Darker is the increased fragility of the 99 percent. Everyone knows the statistic that many ofthis group did not have even $500 of savings for an emergency. What many do not know is that medicalexpenses are the number one cause of personal bankruptcy.
Well, we're in the midst of a global medical emergency.
When the coronavirus passes, as every other virus has, the spendingpropensity and risk appetite of individuals and businesses (large and small)will be greatly diminished. How manyworkers and retirees will have drawn down their IRAs, 401(k)s, and othersavings to keep the lights on?
The world will be in a balance sheet rebuilding exercise where spendingis cut, debts are paid down, and savings restored. This will be true for countries, states,corporations, and individuals.
Corporate America has spent the last 11 years leveraging its balancesheet to buy back stock. Earnings growth has been non-existent in theS&P for the past one and a half years and debt to equity ratios have neverbeen higher.
That sad state of affairs was before the coronavirus and it left corporate America ripe for a culling. Now the corporate herd will be thinned.
As I have written about extensively, half of all corporate debt is rated BBB, the lowest investment grade rating. Much of that BBB paper will be downgraded to junk status. It is already happening with Kraft Heinz, Macy’s and Ford being early adopters of the junk mantle. There will be hundreds more.
This wave of downgrades will have serious knock-on effects forcorporate financing. As these"fallen angels" become junk rated, they will see their cost ofcapital increase. Those further down thejunk spectrum will be crowded out and they will see their cost of capital explode. Many highly indebted firms won’t make it.
For the firms that do make it, higher borrowing costs will crimp cashflows at the exact same time when revenues are collapsing. Earningswill decline precipitously and stock prices will decline to reflect thatreality.
Chart 4: U.S. Corporate Earnings v. S&P 500 Index
Chart 4, above, compares the level of pre-tax corporate profits (white line,upper pane) to the S&P 500 Index (red line, upper pane). The ratio of corporate profits to the S&P500 Index is shown in the bottom pane (green line).
There are a number of interesting items in this chart. The first is that corporate profits have beenrelatively flat since the end of 2011 (because the chart is on a log scale, the8.8 percent growth in profits is difficult to see). However,the stock market continued to advance despite this paltry profit growth.
This stock market rally was just pure margin expansion, meaninginvestors were willing to pay more and more for the same dollar of earnings.
The extent of the S&P 500 disconnect from corporate profits can beseen in the ratio of the two (green line), which, as of year-end 2019, reachedthe lowest it had been since 2002. Thisratio will likely come back to more normal levels. The average corporate profits/SPX ratio forthe past 22 years has been 1.39.
Indeed, it has been over one except during the Tech Bubble and the“everything bubble” period beginning in 2016.
During the bursting of the Technology Bubble and the Global FinancialCrisis (“GFC”), the ratio reached 1.52 and 1.88, respectively.
As with any ratio, it can be altered by changes in the numerator ordenominator, or both. We will getboth. The numerator, corporate profits,will fall, but the denominator, the S&P 500 Index, will have to fall muchfurther if the ratio is to come back to more normal levels.
Table 1: Profit Decline Scenarios and Implied SPX Levels
Table 1, above, models three profit decline scenarios (Columns A-C)and three Profits/SPX Ratio scenarios (Columns D-F). The results are sobering. If U.S. corporations experience a mere 10percent profits decline (optimistic) and the Profits/SPX ratio merely returnsto its 22-year average of 1.39, the implied level of the S&P 500 is 1,380,which is 47 percent lower than where the S&P 500 stands today.
During the bursting of the Technology Bubble, quarterly U.S. CorporateProfits declined by 12 percent. Duringthe GFC they declined by 40 percent. Something between the two is likely for the current decline.
Of course, deeper profit declines coupled with the Profits/SPX Ratiohitting the higher levels that occurred during the Tech Wreck and GFC wouldimply even lower levels for the S&P 500.
For comparison, even with the 22 percent decline in the S&P 500from the peak to Monday’s close (March 30), the Profits/SPX Ratio stands at 0.81,lower than it did at the end of 2019! This would imply significantly more downside for equities.
Conversely, if equities have indeed bottomed, it would suggest thatinvestors have chosen to permanently disregard all economic and companyfundamentals, including: earnings, cash flows, and debt levels, and insteadhave chosen to focus solely on the actions of the Federal Reserve and fiscalmachinations of the U.S. government.
This may very well be the correct focus. If an investor truly believes this, then theonly intellectually consistent portfolio would be 100 percent in equities usingmaximum leverage to get more long. (Protip: don’t do it!)
Governments will not escape the downgrade cycle either, with the UnitedKingdom, Kuwait, and South Africa having been downgraded already. The U.S. had been running trillion-dollardeficits and now deficit spending has gone vertical. The granary doors have been thrown open andthe U.S. government is literally just giving corporations and individualsmoney. Massive debt issuance will follow,increasing our interest expense at the same time revenues are declining.
All this makes a U.S. downgrade a virtual certainty. (Although the ratings agencies will wait awhile to make it more politically palatable and to avoid governmentretribution.)
U.S. states and municipalities are facing the same declining revenuesbut with the added constraint of having to maintain a balanced budget. They will also undergo a wave of downgrades,which will raise their borrowing costs.
Pension returns have been crushed by the Fed’s interest rate suppressionregime in the post-GFC period. Now the10-year U.S. Treasury is yielding 0.69 percent. Most pensions have an actuarial rate of 7.5 percent (the rate of returnneeded to meet their liabilities) and were already underfunded.
They couldn’t achieve their actuarial rate when the stock market was going up 20-plus percent a year and now it’s gotten much harder. As I wrote about in my book, almost all pensions are heading for insolvency and eventually benefits will have to be cut.
Some seem to think that U.S. consumers were in great financial healthand had rebuilt their finances since the GFC. That’s just plain wrong. While itis true that every U.S. consumer no longer owns multiple investment propertieswhile not having a job, they continued to lever up debt in every other way.
Chart 5: U.S. Consumer Debt to Total Labor Force
As can be seen in Chart 5, above, consumer debt per laborer has neverbeen higher.
The world has to go through a deleveraging process where assets are sold to pay down debts. It has only begun.
Investors have a chance to exit risk assets if they missed itbefore. They should take it.
 Source: Bloomberg.
 Source: Bloomberg.
 Source: Bloomberg.
 Javier Blas and Sheela Tobben; “One Corner of U.S. Oil Market Has Already Seen Negative Prices”; Bloomberg; March 27, 2020. Available at: https://www.bloomberg.com/news/articles/2020-03-27/one-corner-of-u-s-oil-market-has-already-seen-negative-prices?sref=S37tDwgl; Accessed March 30, 2020.
 Sydney Temple; “America’s 2019 Rental Market in Review: Did Renters Pay More?”; Abodo; December 30, 2019. Available at: https://www.abodo.com/blog/2019-annual-rent-report/; Accessed March 29, 2020.
 Source: Bloomberg.
 Data obtained from Bloomberg. The S&P 500 closed at 2,627 on March 30, 2020.
 Source: Bloomberg.