Market Upswing Likely Not Start of Real Recovery

Check Your Exuberance
By Michael K. Farr

“We finally saw a big reversal in risk assets on Tuesday as the S&P 500 soared about 10% after suffering a 34% decline from its peak over the previous three weeks. The rally continued on Wednesday. The abrupt change in investor sentiment is attributable to massive fiscal stimulus. Congress has agreed on a $2 trillion package of initiatives, which will be voted on soon in both chambers of Congress and then sent to the president for his signature.  The economy will also get further help from the Fed, which has pulled out all the stops to ensure liquidity in the various capital markets.  This one-two punch of fiscal and monetary stimulus will surely go a long way in stopping the bleeding.  So, crisis averted?  

My strong suspicion is that it's way too early to wave the all-clear sign.  My immediate concern is that while the cash can keep the economic machine oiled, it doesn't get people back at the office, on planes, in restaurants, or in hotels.  Hourly workers are not working as much, and they may go weeks without paychecks.  These folks can't pay rent, and they can't buy food.  When this swath of the economy stalls, does liquidity actually do any good?  Remember Reagan, "A recession is when your neighbor loses his job.  A depression is when you lose yours."  If this disease ramps up and neighbors, friends and family are ill and some die, then most will not need government to tell them to stay home. They will stay home.  I'm not sure how long until we can determine it's safe to go back outside.  This period of enforced or elected isolation may last a good while.  There is simply no way to quantify its effects on the economy or financial assets at this time.

This brings up my second concern. What will be the repercussions for enacting such aggressive policy to fight off the coronavirus?  For the past several years we at Farr, Miller & Washington have been warning that there will be a day of reckoning for the willingness to pursue incremental growth at any cost.  We watched as the Fed held interest rates near zero for nine years, encouraging the build-up of huge amounts of debt, pulling forward demand, inflating asset prices, and exacerbating economic inequality. We then watched the federal government cut taxes when unemployment was running at cyclical lows, causing trillion-dollar deficits as far as the eye can see while only giving a short-term boost to the economy.  We saw well-intentioned efforts to gain trade concessions from China (and others) result in lower exports and supply-chain disruptions for US companies.  We saw efforts to limit legal and illegal immigration reduce the growth in the labor force at a time when workers were in short supply.  And we stood by as Saudi Arabia initiated an oil-price war to, in part, reduce the competitiveness of US energy companies.

All of these policies, which importantly span several presidential administrations, have left our economy ultra-vulnerable to an economic shock at a bad time.  Let me be clear: We at Farr, Miller & Washington in no way were anticipating that a nasty coronavirus would grind the global economy to a halt.  Nobody was.  But we knew an economic shock would come sooner or later, and we knew we weren't remotely inoculated against such a risk.  Ideally, interest rates, debt and federal deficits would have been at more moderate levels when the crisis struck, allowing for more stimulus with less repercussions while also lowering the incentive for businesses to use debt to buy back huge amounts of stock.  Ultra-easy money would not have sustained economically unviable enterprises (including many energy companies) that may not have survived if not for cheap money.  Trade skirmishes would not have been wreaking havoc on supply chains, and healthy rates of immigration would have helped fill labor shortages.  And importantly, we would have been making healthy investments in education and infrastructure to improve labor productivity and economic growth prospects.

But just as assigning blame for coronavirus preparedness is now counterproductive, so is playing Monday-morning quarterback.  The bottom line is that unless and until we begin to see infection rates peak, we are in for a lot of business failures and big spikes in unemployment.  (This morning, we learned that 3.3 million Americans filed for unemployment in the past week!)  But at this time, I'm not sure we have an inkling as to just when that peak might happen.  Three weeks?  Six weeks?  Will there be another outbreak in the fall or next winter?  

 Unfortunately, the response to the coronavirus brings up questions about our public health policy as well.  Are we getting consistent messaging about a credible strategy for eradicating this disease?  From where I sit, the answer is clearly no.  Yes, the stimulus being put in place should help contain business failures and lost jobs for a period of time.  But will it be enough if we can't get this outbreak under control in a reasonable amount of time?

In last week's Market Commentary, we offered up some considerations that might be supportive of markets and the economy.  This week, after a big rally over the past two days, we are arguing that investors should not let their animal spirits run out of control.  There will be a long road back from this economic shock. In the very best case scenario, the Federal government will likely be left with debt levels well in excess of GDP after a few years of huge deficits.  The only way out of debt of that magnitude is monetization (inflate it), which comes with unpredictable implications.  The silver lining, for now, is that interest rates are so low that massive debt is affordable.  What happens when Treasury investors begin to demand higher interest rates to make up for the increased credit risk and devaluation of the dollar?

My guess is that it will take a good deal more time for the market to complete a bottoming process.  If this is indeed the case, investors should be sticking to blue-chip companies with balance sheets built to withstand any eventuality.  Companies heavily dependent on the capital markets for funding should probably be avoided for the time being.  Own businesses with leadership that has had the experience of leading through times such as these.  There are many such blue-chip companies selling at 30-50% off their highs. I think patient dollar-cost averaging makes sense over the next few months.  Stick with quality.  No need to bottom fish for Occidental Petroleum, Carnival Corp or Bed, Bath & Beyond when so many other excellent companies are on sale.

After the huge rally in stocks over the past few days, I firmly believe investors need to resist the temptation to pile back into stocks with both feet in anticipation of a surge right back to the market highs.  That's not the way bear markets work. At times like these, inexperienced investors tend to be in a rush to recover their paper losses.  But it is highly unusual for stocks to quickly recover from a 34% drop (using the S&P 500), in a very short period of time.

Hang in there!  Stay healthy! Peace!

Michael”