February 10, 2020
A few days ago, the market was crashing on Coronavirus fears. But recently, the market has soared back based upon the hopes of a vaccine and some better than expected economic data in the US. The ADP January employment report showed that a net 291k jobs were created, and the ISM Services Index came in at a healthy 55.5. However, a couple of good data points doesn’t change the fact that US economic growth has contracted back to 2% trend growth and will absolutely become more anemic–at least in the short-term. This is because the measures needed to contain the virus are also GDP killers. I have no clue if the virus will become a pandemic or if it will fade away like the SARS and MERS viruses–without long-term economic damage. But, for the stock market to remain at record high valuations, nearly everything has to go perfectly. That is, the Fed has to keep pumping in money, and EPS growth must rebound sharply.
The government reported that real GDP increased by 2.1% in Q4 2018, and nominal GDP increased by 3.6%. Therefore, the BEA wants us to believe that inflation was running at an annual rate of just 1.5% in Q4 of last year. That sleight of hand caused the number to appear respectable. However, going forward, we see many corporations, some of the biggest in the world, warning about a big hit to earnings because of the ancillary effects of the virus-likee closing down many major cities in China. For example, the mighty Tesla stock dropped 21% intraday on February 5 on the announcement of Model 3 delivery delays in China. This is happening in the context of S&P 500 EPS growth that had already flatlined before the outbreak of the virus.
Looking forward to Q2, which is less than two months away, the market will have to deal with the reporting of some really bad economic data and earnings that will be much weaker than Q1. But not only this, it will also have to deal with the Fed’s withdrawal from the REPO market and QE 4. This means the most overvalued stock market in history is going to have to deal with anemic data and a crimp in the monetary hose at the same time.
The most important point is that stocks care much more about liquidity than economic data. With that said, the removal of the Fed’s latest monetary supports should, for a while at least, take a good chunk of air out of this equity bubble. Of course, another market crash will cause Fed Chair Powell to step back in to support stocks, but that will be in response to the chaos, and significant damage has been done. The sad truth is that central bank liquidity has become the paramount functioning mechanism for markets; 2018 proved this beyond a doubt.
In that year, both the ECB and Fed tried to exit—at least to a certain degree–their respective liquidity supports for the market and economy. ECB Chair Mario Draghi said in the summer of 2018:
“We anticipate that after September 2018…we will reduce the monthly pace of the net asset purchases to €15 billion until the end of December 2018. “his feeling at the time was that the QE program had succeeded in its aim of putting inflation on target and fixed Europe’s economy and markets.
In December of 2018, The European Central Bank decided to formally end its 2.6 trillion euro ($2.95 trillion) bond purchase scheme. And, as we all know, the Fed was raising rates and selling off its balance sheet throughout 2018. But, by the end of the year, the liquidity in the junk bond market completely evaporated, and the US equity markets went into freefall. The European SPDR ETF lost nearly 25% during 2018, which will go down in history as the year central banks attempted to normalize monetary policies but failed miserably.
By the time the calendar flipped to 2019, the Fed informed investors that rate hikes were over and, incredibly for most on Wall Street, the march back to free money was in store. By August, the Fed was again cutting rates and then launched QE4 ( $60b per month of bond purchase on October 11). And, at the September 12, 2019 meeting, the Governing Council of the ECB decreased interest rates by ten basis points to -0.5% and restarted an asset purchase program of €20 billion per month. Central banks’ sojourn with normalization didn’t get far off the ground at all. In fact, the Bank of Japan didn’t even attempt it; and they are all now trapped into the never-ending monetary manipulation of markets.
Of course, we recently had another growth scare coming from China’s Wuhan province. The Coronavirus caused Beijing to close down its markets for several days, and when they reopened, the plunge was over 7% in one day. This brought the maniac money printers back in full force. President Xi announced a huge stimulus package to stop the carnage. The People’s Bank of China injected a total of 1.7 trillion yuan ($242 billion) through reverse repos on February 3rd and 4th alone, as the central bank sought to stabilize financial markets. This was the biggest stimulus ever in China. It seems central banks have found a cure for every evil in the world, even a global pandemic: Print More Money!
It was not at all a trend towards more positive economic data that stopped the bleeding — only the promise of a tsunami of new money to be thrown at the market. The faith in governments to borrow and print their way out of every negative event has never been more prevalent—in fact, it is off the charts. The need to prevent a bear market has never been more salient because asset prices have risen to a record percentage of GDP. In other words, the pumping up of asset bubbles and GDP growth have become inextricably linked now that the US market cap of equities as a percentage of GDP is at a record high of 155%.
The truth is that liquidity trumps fundamentals. However, the rush to paper over each problem doesn’t always arrive on time and with enough force. Remember the NASDAQ and Real Estate debacles where equities plunged for many quarters before the Fed’s rate cuts had its desired effect. Central banks will continue to print money with each stock market hissy fit until they no longer are able to do so. The only things that can stop them are if the junk bond market craters at the time when major central banks are already in QE and ZIRP—we are perilously close to that point now. More stimulus at that point just won’t solve the problem.
Or, when inflation begins to run intractable, and the entire fixed-income spectrum begins to revolt—you can never solve an inflation problem by printing more money. If yields are spiking due to the market’s fear of currency debasement, then more QE at that point will cause investors fears of runaway inflation to become completely verified.
It will be at that point where those passively-managed, buy and hold, and indexed investors will be in for a shock. However, having a model that measures the cycles of Inflation/Deflation and Growth/Recession will give investors a fighting chance to maintain their purchasing power through the coming chaos.