May 18, 2020
Hope Springs Eternal
Please read important disclosures HERE.
May 18, 2020
Please read important disclosures HERE.
In light of the pandemic, no one is embracing the stock market’s daily gyrations with particular confidence. Nevertheless, the seemingly surprising gains during the month of April, in which the U.S. stock market, as measured by the S&P 500, rose by more than 12%, provided some reassurance to investors. Yes, with 33 million Americans out of work, which is entirely at odds with the radically more optimistic expectations of just a few months prior, the stock market turned in its best month since 1987.1 The market is still down by modest double-digit amounts for the year, but as of this writing, losses in the U.S. were closer to 10% than the ~30% range investors were absorbing little more than six weeks ago.
A good part of the gain was linked to increasing confidence about the ability to flatten the curve of COVID-19 in the short run, yet plenty of fuel remained for those investors still inclined to fear the worst. To pick a single example, expectations about future corporate profits grew ever more pessimistic, as illustrated in the below chart.
Given the dismal news on the front page of every last newspaper, staying in the stock market in late March and throughout April took tremendous discipline and fortitude. April’s excellent returns bring to mind the aphorism, attributed to many, that a good part of successful long-term investing requires one to “don’t just do something, stand there.”
A 12-Month Perspective
Investors often cherry-pick the worst possible time period to measure portfolio losses, but for those of a more optimistic bent, it is useful to note that from the end of April 2019 to the end of April 2020 the S&P 500 actually recorded a slightly positive return. This seems so incongruous as to beggar belief. Given that the U.S. unemployment rate as recently as February was at a half-century low of 3.5% yet is now said to be above 20%,2 what supports the stock prices of so many (but certainly not all) of the companies with suddenly unemployed workers? As of this writing (things change quickly) the recovery in stock prices seems to be traceable to three major factors: increasing confidence that growth in COVID-19 cases can be mitigated, awareness that the Federal Reserve will do whatever it believes necessary to secure the financial system, and, finally, congressional authorization of trillions of dollars for businesses and workers alongside clear signals that if these trillions aren’t enough, there’s more where that came from.
We will leave the virus-related epidemiology aside and consider the steps taken by the Fed and the Congress.
The Role of the Fed
The Fed is frustrating because while everyone knows it is awesomely powerful, few sensible, educated people really understand its workings. The metaphysical complexity has arguably worsened in the past few months, as there are now no fewer than nine lending programs in place, each one, seemingly, with its own mysterious acronym. Some of these programs are new creations while others are older projects recently expanded, but in any case, these facilities provide an aggregate $2.3 trillion in loans. Some of this money is and will be doled out in partnership with the U.S. Treasury. The historically novel and broader Fed goal is to insulate not only businesses and their balance sheets but also to extend credit to state and local governments.
In addition, the Fed lowered the cost of borrowing by dropping interest rates close to zero. Importantly, the Fed has made it crystal clear that rates will stay very close to zero until after the economy recovers and robust employment is restored.
Last but not least, the Fed has created money out of thin air and has used that money to purchase securities issued by the Department of the Treasury to finance deficit spending. Between March 16 and April 16, the Fed bought nearly $80 billion of securities a day. Other Fed funds will be used to buy debts issued by corporate and municipal borrowers. All told, the Fed’s balance sheet (the bonds owned by the central bank) may soon total $11 trillion, roughly twice the size of the Fed’s balance sheet during the 2008-2009 financial crisis.
The Fed’s aggressive moves have been largely cheered but some details have been the subject of controversy. In particular, the Fed’s intention to create an affiliated entity to backstop the market for publicly traded junk debt has raised eyebrows. Junk is just one step above equity on a business’s capital structure, and if the Fed has said it will buy junk, some wonder if it will go the route of the Central Bank of Japan and start buying stocks should market conditions once again deteriorate. In any case, just as owners of debt securities are reassured to know that the Fed is buying what they own, all else being equal, owners of stocks might well be cheered to know that the Fed might step in to support prices of what they own, too.
Not to Be Outdone
Congress has been busy, too, spending money at unprecedented rates via no less than four economic stimulus packages since March. The most notable features of these packages include unemployment benefits, expanded lending to small businesses, and stimulus checks sent directly to American households. As recently as January of this year, the Congressional Budget Office forecast a $1 trillion deficit, but the federal deficit this year is now projected to be $3.7 trillion and the actual figure will likely prove higher than $4 trillion. To get a sense as to how large a $4 trillion deficit is, consider that in fiscal year 2018 the IRS collected $3.5 trillion in gross taxes.3 This equation prompted influential bond manager Jeffrey Gundlach to ask on his Twitter feed, “If endless borrowing is a viable solution, why did we have any taxation in the first place?”4 Less cynically, Goldman Sachs economist Jan Hatzius measures the fiscal response as so lavish that Americans’ “disposable personal income is likely to register slightly positive growth for this year.”5
In the Balance
Slowing infection rates, an aggressive and inventive Fed, and a free-spending Congress all worked together in April to push U.S. stock prices significantly higher. As ever, stock prices reflect the equilibrium judgments of highly informed market participants, and so we can imagine that for every dollar thinking these same forces will continue to propel the market higher, another dollar is wagered in the belief, commonly heard, that the market needs to fall further to more accurately reflect diminished expectations for future corporate profits. With uncertainty high on many fronts though, it is reasonable to assume that the equilibrium judgments of investors will continue to fluctuate substantially as new developments in the battle with the coronavirus and new updates on the economy provide additional insights into what the future will look like.
2. Wall Street Journal, April Jobs Report, May 3, 2020. https://www.wsj.com/articles/april-jobs-report-likely-to-show-highest-unemployment-rate-on-record-11588514401
3. IRS website. https://www.irs.gov/statistics/soi-tax-stats-irs-data-book
4. Jeffrey Gundlach, Twitter, May 4, 2020. https://twitter.com/TruthGundlach/status/1257487779958648834