The warp-speed nature of the pandemic and economic crisis helps explain the equally-warp speed nature of the stock market’s behavior.
Although the stock market was suggesting a V-shaped recovery, the more likely scenario is rolling Ws.
Rampant speculation, especially in options trading, represents the biggest short-term risk for stocks.
Sir John Marks Templeton was astute when he remarked that “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” If he were alive today, he would likely be surprised at the pace we appear to be going through a full cycle over the past few months. From the depths of despair less than three months ago, after stocks went from February’s all-time high to a bear market with record speed; stocks staged an equally-impressive run from the March low.
I’ve done many virtual client events since the COVID-19 pandemic took us all off the road and into our home offices. Lately, the number one question I’ve been fielding is about the disconnect between the stock market and the economy. As the rain bears down on Main Street, Wall Street has been singing a much sunnier tune; but can it last?
I will not be so daft as to suggest there is anything normal about the nature of this cycle—we have never seen a health crisis morph into an economic crisis by virtue of a government-mandated full-stop shutdown. That helps explain the speed with which stocks reacted from February to March. Although it’s confounding to connect the equally-speedy stock market recovery to today’s economic reality, one could argue that when the S&P 500 was down 34% on March 23 (from the February 19 all-time high) it was discounting the fairly dire economic scenario which quickly unfolded.
In keeping with the high-speed nature of this crisis, the National Bureau of Economic Research (NBER)—the official arbiters of recessions—declared one as having started at the peak in economic activity in February. It was the fastest decision in the 40-year history of the NBER’s recession declarations. Notice the peak in economic activity marked the start of the recession. This is how the NBER looks at the data—once its Business Cycle Dating Committee (BCDC) concludes a recession is underway, they look back to the peak in activity (or thereabouts) as the recession’s commencement. In turn, once they conclude the recession is over, they date the end based on the trough in activity (or thereabouts). This helps explain the fairly consistent history of the stock market’s peaks and troughs coming at or before the peaks and troughs in the economy—after all, the stock market is a leading economic indicator.
Stocks lead economy
The table below shows every post-WWII bear market that had a recession associated with it; including the current bear market. As you can see, with the exception of 2001—when stocks continued to fall after the recession had ended—the stock market’s peaks and troughs have pre-dated the economy’s peaks and troughs (certainly pre-dating the NBER’s declaration dates). What I find myself struggling with today is how the NBER is going to treat the finale of this recession. The severe depth of this recession is such that certain economic data will likely look dire in level terms (i.e., recessionary) long after troughing. My guess is they will take longer to date the recession’s finale than they did its commencement.
Source: Charles Schwab, Bloomberg, National Bureau of Economic Research (NBER), as of 6/12/2020. For illustrative purposes only.
As we look ahead to the second half of the year, we will begin to get clarity on the depth of the economic contraction via both second quarter earnings season, which begins in early-July; and the initial read on second quarter real gross domestic product (GDP) toward the end of July. One of the most-watched GDP forecasts comes from the Federal Reserve Bank of Atlanta—its GDPNow forecast is for a -48.5% quarter/quarter annualized plunge. The Bloomberg consensus for the third quarter is a rebound of nearly +20%. But if GDPNow is anywhere near correct, it will take many strong quarters before the economy is back to its previous level.
The Federal Open Market Committee (FOMC) of the Federal Reserve recently updated its economic projections, and most members don’t expect GDP to return to pre-pandemic levels until 2022; with the unemployment rate at 5.5% by the end of that year. Even with the economy largely reopened, social distancing is likely to prevent millions of workers from returning to work; suggesting long-lasting damage to the economy.
“Stimulus” = inflation risk?
The speed with which the economy sank into a recession was matched by the speed with which the Federal Reserve and Congress acted to provide liquidity and fiscal relief/income replacement (distinct from “stimulus”). Probably the second-most asked question I’ve fielded on client webcasts has been about inflation implications. In sum, we do not think inflation is a near-term risk—although it could be a longer-term risk. For now, the pandemic and its impact on the economy is disinflationary. Although M2 money supply has gone parabolic, its velocity remains anemic (meaning the liquidity remains in the financial system; it’s not picking up velocity in the real economy via the lending and spending channels).
Money Supply Surging, But Not Velocity
Source: Charles Schwab, Bloomberg, Federal Reserve Bank of St. Louis, as of 5/31/2020. The velocity of money is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity is increasing, then more transactions are occurring between individuals in an economy.
With fiscal relief causing the budget deficit to balloon to nearly $4 trillion this year, the trajectory of government debt (which is the cumulative effect of running budget deficits) has accelerated commensurately. Total government debt (inclusive of federal, state and local debt) hit nearly 190% of GDP at the end of the first quarter. This may not represent a future crisis at a particular moment in time; but it does represent a weight on the ability of the economy to grow at anything resembling a robust pace. As you can see in the table accompanying the chart below, in the highest debt zone historically, economic growth (and inflation) have been relatively anemic (the same goes for elevated government spending). Tack that on to a pandemic that caused a screeching economic halt and you have a recipe of fairly weak growth; even if quarterly growth looks good in percentage terms off the bottom.
Weight of Debt
Source: Charles Schwab, ©Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/, as of 3/31/2020.
As mentioned earlier, this is not a normal recession. Historically, as government debt rose, private sector debt eased; with the latter typically more than offsetting the former. In this cycle, there is likely to be a troubling increase in non-financial corporate debt, which was already at an all-time high prior to the pandemic. The good news is that household debt came down dramatically post-financial crisis and remains on sounder footing.
Short-term optimism based on hope or reality?
For now, concerns about longer-term implications of running up a record amount of debt, and/or the long-lasting economic effects of the pandemic, have given way to shorter-term optimism about the trajectory of the recovery. The first two charts below show how the peak in initial unemployment claims generally corresponded to the trough in Apple routing requests. The decline in initial claims is also tied to the hope, by the majority having filed claims, that their layoffs are temporary, not permanent. This may explain why consumers’ confidence in the future has been fairly stable in the face of the implosion in their confidence in their present situation (third chart below).
Claims Decline Connected to Mobility?
Source: Charles Schwab, Bloomberg, as of 6/5/2020. For illustrative purposes only
Source: Charles Schwab, Apple, as of 6/10/2020. For illustrative purposes only.
Consumers More Confident About Future than Present
Source: Charles Schwab, Bloomberg, Conference Board, as of 5/31/2020.
But like with GDP, the carnage in the labor market will take much healing time; especially given the likely continued surge in bankruptcies. In only four months, the cumulative increase in claims has hit a record of more than 45 million—a stark reminder of how much it’s different this time relative to history, as you can see in the chart below.
Cumulative Initial Claims’ Surge
Source: Charles Schwab, Bloomberg, as of 6/5/2020.
Looking ahead, a key data point will be continuing unemployment claims (see chart below), as they represent ongoing recipients of unemployment insurance. Also key will be whether the Bureau of Labor Statistics can get a handle on its “misclassification error,” which meant the 13.3% unemployment rate announced as part of the May jobs report would have been 16.3%. A formal upside revision to the unemployment rate and/or a weaker-than-expected June jobs report could cause a partial conversion in the consumer confidence data shown above. Investors have clearly focused on the adding of 2.5 million payrolls in May; but even if we see similar strength in subsequent months, it still translates into a double-digit unemployment rate for several months to come. Given where stocks were trading until the recent pullback, the risk is high that Wall Street could be in for cloudier skies.
Continuing Claims Easing Off Record High
Source: Charles Schwab, Bloomberg, as of 5/30/2020.
Speculators whistling past the graveyard?
At the end of January, I wrote a report about overly-optimistic investor sentiment and the risk it posed for the stock market, to the extent we got a negative catalyst. Well, we got the mother of all catalysts with the pandemic. At the March low, it would have been difficult to convince investors that by June, the S&P 500 would have recouped the majority of its losses; with the NASDAQ in positive territory for the year. Perhaps the reason for the swift rebound in sentiment is the factor of time. Although in price terms, the 34% decline was severe; but investors haven’t had the same time-based severity—both price and time tend to impact the emotions and behaviors of investors. We’ve recently warned that complacency and even rampant speculation was again a risk for stocks.
Where speculation has been particularly acute is in the options market. I will defer to my brilliant colleague Randy Frederick on most things options-related, as what I know about the options market could be fit in a thimble, with room left over. But I am a long-time student of the put/call ratio and what it says about investor sentiment—after all, the ratio was “invented” by my first boss/mentor, the late-great Marty Zweig. As you can see in the chart below, the five-day moving average of the CBOE equity put/call ratio recently fell to a low not seen since 2000.
Put/Call Lowest Since 2000
Source: Charles Schwab, Bloomberg, as of 6/12/2020.
Another sign of options-related speculation can be seen via Google search trends for the terms “call options” and “day trading” (seen in the chart below). One would think last week’s pullback would have diluted options traders’ speculative juices; but that’s not the case. According to SentimenTrader (ST), the selloff appears to have emboldened them. Last week, the net speculative activity (calls bought to open minus puts bought to open) of the smallest of traders was more than twice as extreme as it was around the February peak; while even the largest of options traders focused to a near-record degree on speculative calls. ST’s Options Speculation Index, which is a comprehensive look at how traders are allocating their volume across speculative vs. hedging activity, moved to the highest level since a few weeks in 2000 (there’s that year again).
Speculation Seen in Google Searches
Source: Charles Schwab, Google, as of 6/14/2020. Numbers represent search interest relative to the highest point on the chart for the given region and time. A value of 100 is the peak popularity for the term. A value of 50 means that the term is half as popular. A score of 0 means there was not enough data for this term.
Another area where we can see similar speculation is the relationship between zombie and non-zombie companies—with the former representing companies not earning enough to pay interest on their debt. As you can see in the charts below, within the larger-cap S&P 500, the non-zombie companies have been handily outperforming the zombie companies—as it “should” be. In contrast, within the smaller cap Russell 2000, it’s the zombie companies leading the pack. I will be keeping a very close eye on investor sentiment—as near-term market peaks and troughs are often defined more by investor emotions than economic data.
Zombies vs. Non-Zombies
Source: Charles Schwab, Bloomberg, as of 6/12/2020. Past performance does not guarantee future results.
Trend matters, but sometimes levels do, too
I am an economic and market optimist at heart; and I believe that “better or worse tends to matter more than good or bad” when it comes to the relationship between economic data and stocks. I also believe in the power of ingenuity, creativity and drive when it comes to our country’s ability to pull itself out of dire crises. But the stock market probably got a bit ahead of itself in pricing in a V-shaped recovery. The latest pullback and increase in volatility has been related to the emergence of a second wave in the virus among a number of early-opener states (I’m not sure we ever exited the first wave). Like was the case in April and May, when there were positive headlines on both therapeutics and vaccines, stocks may continue to be at the mercy of virus-related news—in both directions.
In terms of the economy’s recovery shape, I think the reality for the remainder of this year is likely to be more “rolling Ws” as opposed to a clean “V” (the first part of a W is a V). The reason why a lot of the data improvement looks like a V, it’s mainly a function of opening back up the economy. It will take at least a few months before we see what the post-pandemic “normal” looks like.
Even if federal/state governments opt not to shut down the economy amid second wave concerns, a slowdown in the recovery should be expected based on the impact of weaker demand and constrained supply. Second quarter earnings season may be an eye-opener—not just what’s reported for earnings in the quarter; but what companies say about their second half outlooks. Given that one-third of S&P 500 companies have withdrawn earnings-per-share guidance for 2020, any color will be helpful in shaping views about the shape of the recovery.
Secular economic shift coming?
Longer-term I believe our economy is starting a shift from services/consumer-led growth toward more investment-led growth (in areas like health care, technology and supply-chain manufacturing). The transition is likely to be bumpy and uneven—especially for workers displaced by the havoc wreaked by the pandemic. However, as highlighted in a recent report from Cornerstone Macro, there is hope for employment more broadly:
Employment sectors likely to weaken (number of employees as of May):
- Classic retailers @ 4.55 million
- Restaurants/accommodations @ 7.62 million
- Recreation @ 1.17 million
- Air travel @ .38 million
Employment sectors likely to strengthen (number of employees as of May):
- Grocery stores @ 2.75 million
- Technology @ 5.72 million
- Health care @ 18.89 million
- Manufacturing @ 11.70 million
- Residential construction @ .78 million
The expected growth sectors currently employ nearly 40 million people—nearly three times the 13.7 million employed by the expected contraction sectors. That’s good news; but if the economy is transitioning from having been nearly-70% consumer spending-driven, toward investment-based drivers, the ride is likely to be bumpy.
Chuck Schwab often says that investing is by its nature an act of optimism. I couldn’t agree more. There is reason for optimism that we will emerge from this crisis and forge a stronger path ahead. But be mindful of the emotions of fear and greed—stay disciplined, especially around diversification and periodic rebalancing. Long-term investment success does not require precisely picking market tops and bottoms. That’s gambling on moments in time; while investing should always be a process over time.
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