Market Sentiment With the Long View in Mind

Dear Reader,

What has happened over the past 3 weeks is something that none of us have ever experienced in our entire lives. As a result, the S&P 500 has had a 34% drawdown, 3.3 million unemployed, and some of our leading industries and companies will never recover from the economic paralysis we face. This situation is going to get worse, and we will soon enter a recession. Regardless of where you stand, I am going to lay out some important factors to consider going forward and how they will likely impact you.
First, let’s take a step back from the pandemic and look at our economy from a big-picture perspective. The downturn was inevitable, regardless of COVID. After 12 years of expansion, our consumer debt service payments to income ratio is growing and they are close to 2008 levels. All it takes is to start a downturn is for debt service to outpace income growth, and everyone stops spending. This causes our economy to contract. In a sudden and unpredictable black swan event, it was the virus that stopped our spending. And not just our spending – entire industries have been paralyzed and key businesses are not allowed to generate revenue for a whole quarter. This alone will hurt all of us for at least a year.
All of this is happening while the Fed has lowered the federal funds rate to zero. This is now a trend across the globe, as we have $10 trillion+ in outstanding debt with negative interest rates. This means two things for the United States: the Fed can’t stimulate the economy using rates, and QE will barely raise asset prices. Demand for near-zero interest rate bonds can only go so high. Now the Fed has to turn to riskier means of stimulating. The Fed has turned to “helicopter money” – essentially handing money to institutions and individuals. The $2 trillion in fiscal stimulus that was recently passed is the biggest in history. The risk that this has is causing inflation while incomes decrease, and devaluing the dollar. The dollar is currently at risk for losing its viability as the worlds’ reserve currency, both because of inflation and less foreign demand for US financial assets. While some inflation as a result of this is a risk, it is likely we will see deflation throughout the duration of the recession due to spending on consumer goods and services drastically decreasing.
In these uncertain and difficult times, it may seem that gold would be the best hedge against systematic risk. While gold historically performs well in times of economic hardship, it also has a strong positive correlation to inflation and a negative correlation to deflation. We could see considerable inflation as a result of the Fed's stimulus in the short term. However, we also have a significant amount of outstanding consumer debt service relative to income. Given the considerable drop in incomes - households, consumers, and businesses will likely use this money to pay off their debt and not spend it. This will cause deflation. Not to mention the further economic weakness we are likely to endure that will exacerbate that lack of spending and the decline in prices of financial assets. A bigger risk for the price of Gold is the continuation of the leverage unwind and the liquidity squeeze. Keep this in mind when considering gold as a hedge, or other “safe-haven” assets that are correlated to inflation.
Another major factor affecting the market is volatility. Volatility has likely peaked at the inception of our downturn, but we are sure to see more as it persists. We’re currently in a liquidity crunch, which has adversely impacted highly leveraged assets such as derivatives. Many leveraged ETFs such as $JNUG have reduced their exposure, and over 30 have closed over the past three weeks. This particularly affects leveraged ETFs because, in contrast to common knowledge, many do not amplify the returns of their underlying asset on a total-return basis – they do it on a daily basis. Meaning, daily gains or losses get compounded. If you look at the total max return of many leveraged ETFs, you’ll notice they’ve lost nearly all their value because of this. This effect is magnified by volatility, so keep this mind moving forward if you plan on considering leveraged ETFs as safety assets.
Finally, equities have clearly taken a big hit, though we have seen some rallying as a result of the mass liquidation and Fed response in the past week. The rallying will likely continue, though I wouldn’t recommend you don’t try to time it. The industries most heavily impacted are airlines, hospitality, and staffing. While many of the companies and industries that have been impacted have experienced real drawdowns in their financial performance, and some will go bankrupt, most leading companies will recover and prevail over the long run. Some profitable companies with high earnings potential relative to their prices and healthy balance sheets have lost over 80% of their stock value in the last month. This means there are currently big mispricings in the market. Five years from now, the drawdowns caused by the coronavirus will have no effect on financial performance. This is the best way to think about equities as a retail investor.
In summary, we’re currently in a downturn that is headed towards a recession. It will likely fit the classic “U-shaped” recession (even though we have experienced the biggest fall in the shortest amount of time, looking more like it could be a “V-shaped” recession), in that we have a prolonged recovery period as a result of the unique cause and limited means of stimulation we have. It depends on how and how soon policymakers continue to react. Financial assets will continue to decline, people will continue to lose their jobs, and incomes will fall. In the end, we may have other social, policy, and global financial implications we haven’t seen before. At this point, no one can predict the direction we’re heading in with any certainty. The only thing we can be sure of is that we will get through it. In fact, we will thrive in the long run, as we have at the end of all previous crises. Many of our biggest achievements and innovations in history have resulted from adversity. As G. Michael Hopf said – “Strong men create hard times. Good times create weak men. Weak men create hard times. Hard times create strong men”. While the context doesn’t apply perfectly, that pattern tends to be the cycle in our economy. And it always trends upward in the long run.


Keep Climbing,

Josh Lipman
The Alchanati Campbell and Associates Team