Since late March, the stock market has recovered almost all the losses for the year. It is more impressive than other recoveries we have seen in recent years, because when you look at economic data, there is really no reason for such a strong rally. It is true that the outlook is better than it was in March, but the level of uncertainty is still quite high. It seems market participants believe a vaccine is imminent, government stimulus will keep families and corporations solvent while we wait, and we will be back to normal in the next 6 months. While this is possible, it seems a bit optimistic. In fact, we think many market participants view the re-opening of the economy as a victory and that the economy is already through the trouble and will be back to normal even sooner. We are not so certain.
Looking at actual behavior of consumers tells a different story. While retail sales have come back since April (May was up 17% from April), May was still down 6% from May 2019 and considering that 3%-4% annual growth is typical, this is 10% below expectations for a healthy economy. This means that corporations will be looking at a 10% reduction in revenue vs. expectations.
Since profit margins have recently been about 10% across US corporations, we can expect earnings to be drastically reduced for the second quarter in aggregate. Costs will have been cut as well, but cost cutting that involves reducing the workforce will have future negative consequences as those workers will not have the income to spend as they did before they were laid off. It is hard to believe that the consumer whose income has not been cut is still going to spend as they used to, especially on travel and entertainment. Even if 90% of the economy returns to normal, it is just going to take time to get that last 10% back to normal as firms will not rehire nearly as quickly as they let workers go. In line with this view, the Congressional Budget Office is projecting 10% unemployment for 2021. Our opinion is that corporate profits are going to be slow to come back and the stock market has just not digested this new reality. The rally since March has been a reaction to the massive sell off that started in February and at some point, the underlying fundamentals will be incorporated into market prices.
The wildcard in all of this is the completely unprecedented stimulus from the Federal Reserve and from the US Treasury (CARES Act). This seems to be the driver for the market in the short term as the amount of new dollars in the economy is quite unbelievable. The FED as added $3 trillion to their balance sheet (meaning they bought $3 trillion in bonds) since January and the US government is projected to run a $4 trillion deficit this year vs. the $1 trillion expected pre-pandemic.
This means $6 trillion in unexpected new money that has entered the US financial system. Just to give a more understandable view on these numbers, $6 trillion is about $20,000 per person in the US or $40,000 per US worker. Will this solve the economic problems? It certainly helps and has returned market prices back to where they were before March. At the same time, it is not going to get people to return to their normal lives with a deadly virus making its way around the world.
What happens next is, as always, uncertain, but the risks are more significant that usual and so we will remain defensive in terms of our investment strategy until either market prices reflect economic reality or economic reality improves considerably.
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