The Bipolar States

Two pictures. Two diametrically opposed realities.

Yup, it’s official folks... the US is bipolar - someone pass the lithium....

Signs Of The Times

Short post today... markets continue in LaLaLand mode despite ever increasing COVID cases, choosing to focus instead on the eventual future economic rebound to be fueled by the trillions of added Fed money. Crucial to this expectation is that COVID will soon, very soon, subside.  But, it isn’t, and there are signs of that out there.

Flash back to February.  Despite few cases reported outside of China, the release of the new James Bond movie was moved from April to November.  You bet it wasn’t by accident or “excessive” caution.  When it comes to hundreds of millions in revenue, people make sure they know the facts.

Yesterday, Google announced that it will have ALL its employees work from home until  at least  July 2021.  You think they know something?  You bet they do.

As for 007... Despite the old movie, You Only Live Once, so be cautious and wear your masks my friends - be safe.

US Economy: The No-Fly Zone

If the US economy is bouncing back strongly, how come air travel is not?  The chart is from data by the TSA, and shows passenger traffic down 75% from 2019 levels.

IMHO, the “bounce” is mostly wishful thinking stoked by an absurd stock market bubble feeding on the self same wishful thinking in circular fashion.

Two similes:  The Emperor’s New Clothes (the market is strutting around naked) and The Chicken Game (whoever blinks first could possibly survive).  Both lead to the conclusion that if and when the mood changes - and it could change in a flash - the move down could be a crash unlike any in the history of US markets.

The Debt And COVID Crises - A Markets Retrospective

Today’s subject is the similarity between the Debt Crisis and the COVID Crisis.

Seemingly, there is none -  but if you go back to my old posts from 2006-07 you will observe this:  the debt, asset and derivatives bubble was obvious for all to see well before it burst, yet markets kept on rising, acting as if everything was hunky-dory.  It took almost a year and a half of la-di-dah until the bottom fell out in mid 2008 (Chart 1).

Chart 1

Here’s patting myself on the back: on my Decnember 31, 2006 post, I had predicted a “rational” level for S&P 500 in the range of 580-700.  On that day the index had reached a high of 1575. It bottomed out in early March 2009 at 660 for a whopping 58% drop, but who’s counting, eh?

Well.... I am!  More  specifically,  on my 2006 New Year’s Eve post I wrote:  “...this implies an ultimate drop of 59% from current levels for US stocks.”  Ok, I’ll give myself a double pat on the back!  I was wrong on one thing, though.  I thought that such a big drop would take five, or even ten, years.  It ended up happening - top to bottom - in just two.

Credentials established, let’s move on to the present (beware, as usual, that past performance is no guarantee of future success),

First, three general  observations:

1. The stock market has become unusually volatile in the last five years.  Moves, up or down, happen extremely fast - in a matter of days, if not hours.  This has a lot do with a) flash/algo trading and b) the prevalence of tracker ETFs which are forced to buy/sell in robot fashion.  Markets move fast nowadays.
2. Interest rates are zero or negative across the largest part of the global economy: USA, EU, Japan.  Central banks have no more conventional weapons left with which to fight recessions and are now just printing money.  There is even a newfangled, pseudoscientific term for it: Modern Monetary Theory.  
3. COVID is a Real Economy crisis: it destroys jobs and incomes, leading to a much lower marginal propensity to spend, particularly on unnecessary goods and services.  This is a once in a lifetime, in-your-face lethal pandemic, not some dotcom or subprime loan bubble.  You can easily ignore a bunch of foreclosures happening two towns away, but record viral infections are huge alarm bells.  So what?  You SAVE your cash, that’s what...

Ok, then.  After a fast and furious decline, markets are now discounting a V-shaped fast and furious economic rebound.  There are zero signs of it happening thus far, but the stock market has discounted it, and more, particularly in the tech sector.

US market capitalization is at 148% of GDP, just about the highest level in history - and this is based on 2019 GDP.  Factor in that 2020 GDP will be at least 6% lower and the ratio goes to 157% (Charts 2, 3).

Charts 2, 3

Back in 12/31/2006 my prediction for a massive market drop was based on DPI (Disposable Personal Income) and debt service, appropriate metrics for a Debt Bubble.  Today, I will base my prediction on GDP, since this is an economic crisis.

Bottom line, then: IMHO, look for Market Cap / GDP to revert to a range of 75% - 100%.  As of today, this would mean a range of 1.600 - 2.130 for SP500 vs. 3.200.  And that’s without accounting for the possibility for even lower GDP.

Notice how for 30 years between 1970-2000 total cap was below GDP and afterwards rose above it only during the dotcom and Debt Bubbles.  But since 2016 it has gone wild, mostly because President Trump slashed corporate tax rates to the lowest level in nearly a century.

Here’s a question: given the current, unprecedented budget deficit for FY 2020 (another is probable for 2021, too) what is the next President going to do to repair the damage?  And what will higher corporate taxes do to share valuations?

There’s Only One Buyer -The Fed

Sooner or later (my bet is sooner) investors and speculators will realize that the Fed is currently the only major buyer for US stocks and bonds - at least indirectly, if not directly since the US central bank is prohibited from buying shares (other central banks aren’t, e.g. the Swiss National Bank has a portfolio valued at over $95 billion in stocks).

What do I mean by indirectly? Simple: the Fed has flooded the system with $3 trillion, ballooning its balance sheet from $4.2 to $7.2 trillion in mere weeks.  By comparison, it took 20 years for the Fed’s assets to rise from $1 trillion to $4 trillion (Chart 1). To be clear, that’s  fresh dollars circulating in the system.

Chart 1

(Note: There is a parallel observation to be made on Chart 1;  after dealing with the Credit Crisis in 2008-10 by doubling assets to $2 trillion, the Fed kept printing money and reached to $4.5 trillion.  It’s no wonder stock prices, bonds, real estate, etc. kept rising and rising.)

So, asset prices are being boosted by the Fed’s printing presses for a long time now.  The latest injection is, therefore, not unusual - it’s just spectacularly enormous.and furiously fast.  I think, dear reader, you understand why I say that the Fed is, essentially, the only buyer.

What would happen if the printing presses stopped, or if they started running in reverse? How long would it take for trigger-happy speculators to realize there’s no one else left to buy their overbloated portfolios?  To quote one of my (very) old posts, how long before people realize they own trading sardines rather than eating sardines? (RIP Sandra K. 😢).

It’s very early days to conclude that the Fed is reversing course, but the last few weeks have seen its balance sheet shrink, if only modestly (Chart 2).

More to follow as data become available on this, the Moral Hazard to end all moral hazards..

Chart 2

Smart Money Moves - Warren Buffett

Berkshire Energy announced a $9.7 billion deal to acquire the natural gas pipeline and storage facility business of Dominion.  It is being interpreted  as a vote of confidence for the economy by Warren Buffett.  Nothing could be further from the truth.

First of all, the deal involves $4 billion in cash and the assumption of $5.7 billion in debt.  That’s a tiny investment for Berkshire Hathaway which had accumulated $137 billion in cash at the end of 1Q20 (the deal “consumes” just 2.9% of the cash hoard).

Secondly, the gas pipeline business is a highly regulated utility that produces stable annual returns, a very good alternative to, say, government bonds.

So, if anything, this is a vote of NON confidence by Mr. Buffett.  It’s not as if he’s buying anything related to a V recovery, consumer spending, etc. represented by the “bargains” in the travel and leisure or retail sectors.

The sage is being as conservative as possible.

Employment Data - Not All Job Gains Are Created Equal

According to the Bureau of Labor Statistics (BLS) the US added a total of 7.5 million jobs in May and June, after suffering a massive wave of 32 million layoffs in March and April due to COVID (Chart 1).  Mr. Trump gave himself laurels and markets (the only thing that apparently matters in this Brave New World)  cheered loudly.

Chart 1

But let’s look beyond the headline numbers.

In March and April 2020 the economy lost 32 million jobs;  8.5 million of them where in the Leisure and Hospitality sector, accounting for 27% of all job losses.  This same sector added back 3.5 million jobs in May - June (Charts 2 and 3) accounting for an oversize 47% of all jobs gained.

=> Keep this in mind: Leisure and Hospitality was 27% of all jobs lost, but 47% of all jobs gained back.

Chart 2

Chart 3

Why is this important? Because those are part-time, very low paying jobs: On average, such employees work only 25.5 hours per week and make $17/hr. (Table 1).   In fact, Leisure and Hospitality employees work the fewest hours and get paid the least wages of ALL employees. By comparison, the national averages for all private employees are 34.4 hours/week and $28/hr.

Table 1

Let’s do a bit of math: in March - April the private sector lost 32 million jobs worth:

 23.5 million jobs x 9 weeks x 34.4 hrs x $28 = $204 billion in non L&H jobs
Plus
8.5 million jobs x 9 weeks x 25.5 hrs x $17 = $33 billion in L&H jobs
for a total of $237 billion.

In May-June the economy gained 7.5 million jobs worth:

4.0 million jobs x 9 weeks x 34.4 hrs x $28 = $35 billion in non L&H jobs
Plus
3.5 million jobs x 9 weeks x 25.5 hrs x $17 = $14 billion in L&H jobs
for a total of $49 billion.

That’s a very long way from repairing the damage done to the real economy, no matter what Mr. Trump or stock indexes say.

(Looking at it another way, each job lost was worth $7.400, but each job gained only $6.500 - the economy is adding back mostly low value-added, low-paying jobs.)

Consumer Spending Will Make Or Break The Economy

Personal consumption makes up the vast majority of GDP in the United States, currently around 68-69% (see Chart 1).

Chart 1

So, what people choose to do with their disposable income (i.e. after taxes and deductions) is crucial for the economy: they can spend it, or save it.  This behavioral pattern, called Marginal Propensity to Spend, can be easily deduced by the difference between Disposable Income and Personal Consumption Expenditure, in dollar terms (see Chart 2).

Chart 2

Right before the COVID crisis Americans as a whole spent on average almost 90% of their disposable income (caveat: lower income families routinely spend 100% or more of their income, i.e. they go into debt, while richer ones save and invest more).  The gap between disposable income and consumer spending was running around $2 trillion per year, or just about 10% of GDP, and jumped to almost $7 trillion, a historically unprecedented 35% of GDP (all the figures are annualized) as the Trump administration sent everyone those $1.200 checks which people on lockdown had nowhere to spend (again, not the poorer folks).

The gap has now narrowed to a still enormous approx.  $5 trillion since there are no more handout checks and the US is slowly emerging from the lockdown with consumption boosted by pent up demand.

In my opinion, this is the single most important indicator of the economy’s current condition.  I will be watching closely, but I think that the Marginal Propensity to Spend will remain muted for quite some time and cause the economy to drag, instead of bounce.