Summary
- The “slow growth forever” global economy is the backdrop for at least another decade meaning deflationary pressure.
- The stock market is coming off of a massive November up move.
- COVID-19 2nd and 3rd waves are raging globally, including in the U.S.
- Economic indicators are that had rebounded sharply off of the “essentials only” slowdown, are now starting to turn and threaten to go flat.
- The U.S. Treasury taking away the Fed’s bazooka leaves the stock market very exposed to a rough period.
In my “2020 Outlook – Euphoria To Despair,” I laid out a case for an early year volatility event. As Coronavirus hit the news I discussed in several articles and webinars how it could cause a major correction.
I further suggested that “I see thee S&P 500 getting to the middle 3000s.” I then continued with this:
“I believe a second half correction will happen no matter what. It could accelerate much like it did in 2018 if President Trump loses. I believe that 2020 ends with an S&P 500 around 2200 to 2400 in this scenario.”
Since then of course, we did see a massive correction, followed by massive capital injections by the U.S. Treasury and Federal Reserve. The result has been a massive stock market rally in the face of economic depression conditions for a large portion of the population.
So, the question becomes, can the rally continue, or are their forces gathering that can drive the stock market into a significant correction? We talk about that today.
The Slow Growth Forever Global Economy
The backdrop for the global economy that we work from is what I called years ago “the slow growth forever global economy.” The crux of that argument is that there are deflationary economic forces at work that governments are trying in vain to counteract with inflationary policy.
The core deflationary pressures are:
- aging demographics.
- massive global debt.
- technology.
The core inflationary pressures are:
- Central Bank quantitative easing, i.e. monetizing debt.
- Government stimulus efforts.
The problem with stimulative policy responses is that more debt has been created, leading to more future deflationary pressure.
With global debt having embarked on a massive binge since the early 1980s, old debt is now rolling up on new debt. This perpetuates a problem that is not cyclical in nature, but secular, that is, structural.
The structural problems of deflationary aging demographics is complicated by technology, which both improves quality of life, but disrupts the economic paradigms.
Eventually, aging demographics will even out, however, that will not be for decades, making is a “forever” problem as far as investors are concerned.
Technology is likely to always be deflationary, though, evidence suggests there will be a prolonged plateau period at some time where the impact is muted. I would guess that plateau period is sometime after the 2020s which is flying face first into the 5G-IoT-AI age.
Debts only continue to increase, demanding even more deficit spending and central bank programs to offset it, creating more debts, that require even more deficit spending and central bank programs to offset it… you can see the problem there.
We are now engaged in a debate on how to rectify these problems. Modern Monetary Theory, or MMT, is getting significant attention. In short, MMT suggests that nations that control their own currency can print money, without creating debt, until inflation kicks in.
I contend that QE infinity and MMT both have only one outcome, which timing is difficult to nail down. We will eventually see a sharp rise in inflation and interest rates. I have long suggested this would occur near the end of the 2020s or around 2030, when the last baby boomers are receiving Medicare and Social Security.
Secular Decline Meets An Economic Shock
In my outlook for 2020, I suggested that we were in for a mild cyclical economic slowdown. Instead, as the economy was just starting to go from plateau to a slowdown, Coronavirus COVID-19 hit.
The pandemic has turned out to be the sharpest and deepest economic shock in over a century, eclipsing The Great Depression.
Only a massive policy response likely saved the whole of the economy from a depression. As it stands, the depression is restricted to people on the wrong leg of the “K shaped” recovery.
Because the bulk of the economic stimulus was cash that found its way into the banking system and fixed income markets, it also acted as a massive stimulus for the stock market, far more than the economy.
Economics Now
Today we saw that PMI fell from September and October:
While the move is minor, it is indicative of a weakening recovery.
The more worrying number this week is the potential of a higher unemployment print. This is something I warned was coming for year-end and early 2021 a couple months ago in: High Wage Layoffs Will Sink Stocks Soon.
Last week, new U.S. jobless claims came in at 778,000, which was 48,000 higher than consensus forecasts. While an improvement from April, that remains higher unemployment claims than the peak of any other recession.
That’s only the tip of the iceberg though. Another 312,ooo applied for Pandemic Unemployment Assistance – PUA. A total of over 1.1 million applied for unemployment benefits of some kind, marking the 36th consecutive week of higher claims than the highest week of the 2008-09 Great Recession.
Unfortunately, there’s more. The day after Christmas, according to The Century Foundation, over 12 million people will lose unemployment benefits tied to the CARES Act.
While there has certainly been a rebound in employment from the “shut down,” the economy has approximately 10.1 million jobs fewer than pre-pandemic. This means that the path to nearly full employment again will take years.
The impact on spending and investing could be massive in early 2021 if Congress does not quickly move to extend at least partially some of the CARES Act unemployment relief.
Recovery From COVID-19 Is More Than A Shot Away
Across the globe, 2nd and 3rd waves of Coronavirus COVID-19 are raging. In the U.S. hospital resource use is at its highest point and still surging higher.
The reproduction rate of the virus is still a shade above 1, meaning that every person who gets COVID-19 is passing it on to at least one other person. In other words, we are seeing no progress in bending the infection curve down.
Globally, the numbers are scattered, but there is clear economic damage as various regions undergo further restrictions on gatherings with impact on economic activity.
The recent hype of mRNA vaccines from Moderna (MRNA) and Pfizer (PFE) has been a positive for stocks, in particular oil stocks. I would caution that mRNA comes with unknown risks. The Jerusalem Post asks a very important question: Could mRNA COVID-19 vaccines be dangerous in the long-term?
Because of the unknowns, mRNA vaccines are unlikely to be used to inoculate most of the population in the short-term. Rather, mRNA, and DNA based, are likely to be emergency use shots that give way to more traditional shots by H2 2021. Even if mRNA or DNA based vaccines proves to be among the best, we won’t have that safety data for years.
More traditional shots, such as from Merck (MRK), Sanofi (SNY) and Novavax (NVAX), are not likely to be available until summer of 2021 at the earliest. These candidates come without many of the long-term safety unknowns of the mRNA and DNA competition.
As subscribers to my investment letter and those who watch my webinars know, I have said since March that I believe we have emergency use vaccines around New Year. I do not believe we are vaccinated en masse until at least summer 2021 though. So far, those thoughts seem on track.
With markets excited about a return to normal by summer 2021, there is a fine line on what the impact could be with a pushing out of that timeline.
The Stock Market Is Still Overvalued
Advisor Perspectives makes this easy to get and if you haven’t seen it before. This is a combined measure of 4 different valuation measures.
The stock market is higher valued than in 2007 and roughly the same as the tech boom.
Here is a recent measure favored by Warren Buffett:
And a similar method using the Wilshire 5000:
Both Buffett related measures are the highest in history. That might explain the extremely high cash position that Berkshire Hathaway (BRK.B) has.
This valuation chart shows P/E ratios relative to inflation.
That chart indicates that if we should see inflation, then the corresponding rise in interest rates could be particularly damaging to stock valuations and price.
Leverage On Leverage
Margin debt has shot back up since the sell-off in March. Once again, margin is reaching historic highs last seen before the December 2018 stock market correction.
Dangerously, the new group of retail, mostly Millennial, traders are using margin to buy call options.
We have not see this type of leverage on leverage since 1999 and 2007.
I can only wonder at what point that leverage on leverage is spurred to deleverage, like in March.
Is The Money Printer At Risk?
The week before Thanksgiving, U.S. Treasury Secretary Steven Mnuchin announced he would be pulling over $400 billion from the Federal Reserve’s market support programs.
The programs to be closed are:
- The Primary & Secondary Market Corporate Credit Facilities which have been largely credited with shoring the corporate credit market.
- The Term Asset-Backed Securities Loan Facility [TALF] designed to support the markets for credit-card loans, automobile loans, student loans, certain types of business and insurance loans, and leveraged loans.
- The Main Street Lending Program which was designed to help small and medium sized businesses but was largely unused. Mnunchin wants this money converted to grants.
- The Municipal Liquidity Facility which was created to lend directly to state and local governments. This program is hated by Republicans, particularly, President Trump. Despite being lightly used, without it, many cities and states will rely on Federal assistance in 2021 that might not be coming.
The corporate credit facilities had a significant impact on the stock market as many companies were indirectly bailed out by not only the Fed buying a small portion of the corporate bond market for the first time, but the promise of a backstop. Hundreds of companies were able to refinance their debts and take more debt with the Fed behind the market.
Without the Fed behind the corporate bond market in such a big way, any economic disappointments or shocks could send bonds and stocks down.
Another large credit problem is that the Federal Reserve has a shrinking pool of U.S. debt to monetize via quantitative easing. This is why Fed Presidents and Federal Reserve Chairman Powell have been asking for fiscal stimulus – the Federal Reserve needs more debt to monetize.
Over $4.6 trillion of the $7.2T Fed balance sheets is U.S. Treasury debt. That represents nearly $1 of every $6 issued of all U.S. government debt.
As you can see, the CARES Act debt provided the Federal Reserve with the ammunition for its bazooka.
I gave a discussion of the Treasury and Fed in last week’s Macro & ETFriday webinar:
Quick Investment Thoughts
When valuations are so high, it is easy to see that there are multiple reasons stock prices could fall. At current valuations, there are very few stocks to buy and fewer ETFs.
The most obvious reason the market can correct soon is that the economy might not recover as quickly as many think. If news in the short run clouds that recovery picture, markets would likely react ahead of time. In that case, valuations could easily be reset to under 20 again, which implies a bear market.
The flip side is that the economy could reignite hot and create a sharp rebound in velocity of money. Should that happen, then inflation could shoot past the 2-2.5% Fed target quickly, necessitating higher interest rates. There is clearly room for velocity of money to rebound:
The deflation versus inflation conundrum is a double edged sword at this point.
A wildcard that nobody expects is less liquidity from the Fed. It is so ingrained in people that the Fed will pump stock prices forever that they forget the recent past. The stock market chopped sideways for two years in 2015 and 2016. We saw two corrections in 2018.
I once again raise the warning flag against FOMO driven chasing. Trim winners, sell losers and be very selective in what you buy (members of Margin of Safety see the companion piece: “Stocks of the Week” and watch tonight’s private webinar).
