Monday, July 13, 2020

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?

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