Stock markets have dislocated from fundamentals. The economic fundamentals are almost as bad as they have ever been. Stock market valuations are almost as expensive as they have ever been. But that hasn't concerned markets for the past six weeks and, to be frank, it doesn't look like concerning markets any time soon.
This is presenting you with a rare second chance to sell stocks in the face of the worst economic shock of our lifetime.
For complete disclosure, there is another alternative. That alternative is that markets are now entirely dependent on central bank support, so economics and fundamentals no longer matter. This is a possibility.
It is also an ironic logical progression: Capitalism is dead, therefore buy stocks.
Why has the market risen?
I'm putting the rise down to three main factors:
- Central bank money printing leaving more money in markets.
- Momentum traders, robots and retail traders chasing the bounce higher.
- Inequality getting worse, rich people are more likely to keep their jobs and so are investing more because there are limited opportunities to consume
Could this simply be the "new normal"?
The question is whether weak profits will eventually bring this back to reality. I guess it is possible stockmarkets ignore earnings for 3-5 years until profits recover. But I think it unlikely.
The "stock markets will eventually recover" argument is a favourite argument of the perma-bulls. The underlying logic of this argument is nothing bad ever matters because stock prices will eventually recover. The logic is (mostly) true, but last I checked the ASX 200 was still below 2007 levels - 13 years is a long time for prices to go nowhere if you go all-in at the wrong time. I'm assuming you are still reading because you don't want to wait that long.
What could bring markets back to reality?
I don't know. So far the following have failed:
- terrible Q1 earnings and falling outlook
- a failure to control the virus in the US
- rampant virus activity in developing countries
- the likely intensification of the US/China trade war
- widespread rioting in the US
My best guess is a mix of bankruptcies and weak earnings will eventually do it. It might take six months. It might take six minutes.
A Biden win in the US has the potential to shock the market with higher taxes and wages. I expect this will actually be good for profits in the long term, but it might be enough to shock the market back to reality in the short term.
The danger for investors who have a plan to "run with the herd" and then sell when the market turns is that there seem to be a lot of other investors with a similar strategy. And given markets have set records for the speed of both downward and upward movements, you will want to very confident of your ability to get out at the right time.
What about central bank support?
The arguments are:
- Central bank liquidity will overwhelm insolvency risks.
- Government stimulus overwhelms the economic damage.
It is not a particularly nuanced argument. Central banks will buy or fund everything. If our defensive position is wrong, this is probably going to be why.
Dig a little deeper, and the argument is less convincing. Governments and central banks have a choice:
- take more pain earlier and recover faster
- delay the pain and have a much more drawn out recovery
Governments and central banks are opting for the second. Which means investors are going to have a lot longer to wait for company profits to recover.
Can central banks and governments prop up failing large companies?
They can and will.
There is a slight question about how long for. However, the reaction to pretty much every debt crisis since Japan in the 1990s has been to prop up zombie companies. I think the plan is that if you give these companies enough low-interest debt then you can see out your term and leave any problems to your successor.
I expect zombie companies to proliferate. Companies with such enormous debt burdens and low profits that they have little hope of ever paying off the debt. Which means the recovery will take longer.
Can central banks and governments prop up failing small and medium businesses?
These companies make up 50-70% of most economies. They don't have listed debt that central banks can buy.
It is extremely hard to prop up small businesses. The fraud risks are too high. Take a loan, transfer your assets into your wife's name, pay your brother-in-law for some fit-out, declare bankruptcy.
The Australian government tried to support small and medium businesses by offering partial loan guarantees for up to $40b of bank lending. The actual amount of credit looks like it will be closer to $4b - i.e. 90% lower than announced.
It is hard to support this part of the economy. I'm yet to see a proposal anywhere which looks workable.
Can central banks and governments continue to pay people not to work?
Yes. The question is how long for. Many governments put in place short term measures to support earnings for displaced workers. Most plans tail off over the next six months.
In most developed countries the virus is now contained enough that hospitals are not over-run. Which means economies are at the stage where the imperative will become finding people new jobs rather than paying them not to do their old jobs.
Will we see governments continue to pay elevated unemployment benefits to displaced workers for years? Possibly, but this once again, this will delay any recovery.
Concern 1: Lack of consumer demand.
Before Covid-19, even though consumers had been growing debt faster than income for years, consumer demand was still weak. Now consumers have lost jobs in record numbers, have been locked at home, face threats of future lockdowns and banks are tightening lending criteria. All the evidence so far suggests that it will be a long time before consumer demand returns.
An often-cited argument is there will be pent up demand from people stuck at home unable to spend money. This is a rich person's argument:
There will definitely be winners. But the impact of a few winners spending more money will be drowned out by the legion of people with less money. And rich people won't be able to spend on travel for some time. And there will be winners who decide to save money in case there is a second wave.
Concern 2: Debt Crises
Consumer debt is close to record highs. Corporate debt in the US is at cyclical highs. Add in weak consumer demand and supply shocks. All the conditions are present for a debt crisis.
The best argument is that central banks and governments will "do something" when it becomes an issue. They might. I have no idea what, but it would be hugely expensive and incredibly prone to fraud. Effectively it would be suspending capitalism.
Concern 3: Corporate Earnings and Valuation.
On top of the above problems, I see companies:
- running lower debt levels
- adding more redundancy into systems
- adding more fat into supply chains
- diversifying supply chains away from China.
All of these will reduce earnings even further. And I'm not talking about the one-off impact this year, I'm talking about a long term decrease in earnings potential.
Earnings are cratering. Australian forward valuations have never been this high. US valuations were only higher during the tech wreck.
The numbers are messed up at the moment. Growth rates are so large in both directions that they are virtually meaningless. The focus for investors should be on where earnings can get back to over the next few years. And I'm struggling to find anyone with a credible earnings scenario that would justify paying current prices.
I'm betting central banks and governments won't suspend capitalism forever.
There were a lot of superannuation funds and investors who completely missed the virus coming and rode the stock market all the way down and then most of the way back. They have been gifted a second opportunity to sell. My bet is very few will take the opportunity.
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Damien, interesting overview and I do like the illustration of charts. I see your fund is running at 2% cash weighting and down -4% (Core Australia) for the year. I presume based on the scenarios you outlined above, more investors should sell and switch to more cash?
Where to from here? In the corp debt to GDP graph (early 90s, early 00s and GFC) there was room to move with interest rates.. what's to happen now with interest rates already at historic lows?
A strong summary Damien. The setup is similar to late 2007, when equities kept partying whilst credit was cactus.
Thanks Rahul - you are looking at a fund we run that must always be fully invested in Australian stocks. Of our tactical funds (which do switch between stocks, cash and bonds), our highest risk fund is up 8.7% over the year and yes, we hold much higher levels of cash and bonds at the moment.
Hi James. You have struck the nail right on its head...
excellent article.. and right on time too... luckily I sold all my holdings except gold today and bought a lot of bboz.. waiting for party to start
Great read Damien, and love your headline! How about that timing too? Dow down nearly 7% overnight.
Thanks Patrick. I wish I could take credit for the timing. I guess I should have posted it on Livewire at the same time that we ran the podcast yesterday morning!
Nailed it (again) Damien!
On the money as usual Damien. Kudos.
Damien Well put. Despite the logic the FOMO is playing on most investors mind and presents temptations to follow the herd. I personally think that eventually logic must prevail its a question of When. Thank you Damien for a thoughtful piece John
Bravo! That's a really balanced view of what potentially lies ahead. I wish more Economists and News reports would speak openly about the risks. Most seem to put marketing spin into their viewpoints so as not to panic the public.
Good synthesis Damien - thanks for sharing
Eric, from my experience over the years from 87 / 2000 / 2008 2009 and now 2000 I have to agree that the people who have started momentum investing in the last month would be far better off taking their profit if market rally on Monday !!
They have been gifted a second opportunity to sell. My bet is very few will take the opportunity. In which case, the market will not tank and they will be justified!
Hi Damien. A very good article and a salutary warning. I am thinking there is a problem with your first option: take more pain earlier and recover faster. This is not a regular economic cycle. It is a biological issue which has been handled appallingly by every government including our own. If we had blocked every country when we blocked China we would be in a much better position now. There is no guarantee that taking financial pain now will lead to a faster financial recovery. The issue is biological not financial. Therefore there is no incentive for central banks to ease up on the easing up. It's got a long long way to go.
Really hope good take Damien, thanks, and U like your reasoning. Downturns always end in the debt markets in my experience as revenues drop away and debt remains. A brand name in US corporate debt will be most likely where it shows up, especially if they face a re-rating out of investment-grade bonds. I hope I’m wrong.
Hi Damien, Interesting article. However I think you are too pessimistic and there may be other time lines for how the future will unfold. (1) Why do you post results for the ASX and not for the Dow and the NASDAQ? I have just run a chart for these three indices from 13/6/2007 to 13/6/2020. In this time frame the All Ords is down 5.56%, the Dow is up 90.96% and the NASDAQ is up 268.34%. I ask you to do an analysis on why the ASX underperforms the major US indices on 10, 20 and 30 year time frames (even taking into account our higher dividend rate). (2) If you define capitalism as private ownership of all assets then yes we are in new times. But if central banks and governments become new owners then it is still a form of capitalism - maybe a better form since the huge influx of capital by central banks has seemingly averted major market crashes both for the GFC and this pandemic? (3) You say central banks can "take more pain earlier and recover faster". Is this really an option? Firstly there is the danger that if more damage is taken now, the recovery will actually be slower and even more difficult - so your proposition is contradictory? Damage also flows from the capital markets to the real economy - partly why the Great Depression was so bad. Also what should central banks do? - by pumping huge liquidity/capital into the system they have effectively stopped the market crash globally. If the market gets worse or is more prolonged the damage gets worse and goes into the real economy more. Also people and companies want their jobs/businesses to be protected now - not some time in the future based on some ideological arguments. In my opinion the Federal Reserve did exactly what was needed both for the GFC and also this pandemic and the Reserve Bank of Australia should have intervened more in the GFC.
Brilliant thoughts in this article Damien and you've summed the whole situation up perfectly in my opinion. One massive reason I see for low growth continuing is the power of the internet with its ability for undercutting prices on a continuing basis. This has happened with goods and is now happening with services. This benefits companies like Amazon and Google and tech companies to the detriment of most other businesses. We are now in a race to the bottom which is why quality of goods produced is so crap these days. Services are now following.
HI David Heath - you have cut the legs from under your own argument! Expand your window a little and you will find the Nasdaq took 15 years to get back to 2000 levels. And trust me, if you look at how the Dow is calculated you will understand why no one benchmarks themselves to that index. I'm not arguing against any central bank intervention. At one end of the intervention spectrum, you have no intervention - call this 0 out of 10. At the other end you get central banks to buy every single asset, and never allow another company to go broke ever again. Call this 10 out of 10. I'm saying that markets are pricing assets like we are headed for an 8 or 9, which I think will create not just zombie companies but zombie economies which will have long slow growth forever. I think central banks would be far better off at 5 or 6 on the intervention spectrum.
Thank you … I will be taking up my second chance ….
Very interesting article. So many contradictory thoughts out there, so hard to make (the right) decisions. Two years ago, stressed out by share markets, I closed my SMSF and threw it to an industry fund. Let them take the stress. All good up until this drama - before the bottom I cashed out, missed the upswing and am now totally unsure whether to "nibble" back in to various options, or whether I'll again live to regret it if/when market plunges again. Or regret staying on sidelines when market keeps rising? Do I need a financial advisor or a shrink!!??
The last few months have experienced the best dead cat bounce I've ever seen, propped up by government money and ma and pa kettle looking for better than zero percent returns. Everyone's climbing on board in this latest round of optimism and know one wants to miss out the easy returns. People who've never traded before, have taken up trading after sitting at home looking for something to do. Adding more fuel to the fire! You know what fires do right? I've seen it all before. The calm before the storm! which is brewing again and believe me it's going to rip through financial markets like a slow moving tornado. I thought the chance to sell out had come about a week ago but I was wrong, you still have time.... Don't wait until the heard moves, act now! Or take up short selling:)