You are being given a rare second chance to sell stocks

Stock markets have dislocated from fundamentals. The economic fundamentals are almost as bad as they have ever been. Stock market valuations are almost as expensive as they have ever been. But that hasn’t concerned markets for the past six weeks and, to be frank, it doesn’t look like concerning markets any time soon.

This is presenting you with a rare second chance to sell stocks in the face of the worst economic shock of our lifetime. 

For complete disclosure, there is another alternative. That alternative is that markets are now entirely dependent on central bank support, so economics and fundamentals no longer matter. This is a possibility. 

It is also an ironic logical progression: Capitalism is dead, therefore buy stocks. 

Why has the market risen?

I’m putting the rise down to three main factors:

  1. Central bank money printing leaving more money in markets.
  2. Momentum traders, robots and retail traders chasing the bounce higher.
  3. Inequality getting worse, rich people are more likely to keep their jobs and so are investing more because there are limited opportunities to consume  
Trading accounts up substantially
Investor confidence up, consumer confidence down

Could this simply be the “new normal”?

The question is whether weak profits will eventually bring this back to reality. I guess it is possible stockmarkets ignore earnings for 3-5 years until profits recover. But I think it unlikely.

The “stock markets will eventually recover” argument is a favourite argument of the perma-bulls. The underlying logic of this argument is nothing bad ever matters because stock prices will eventually recover. The logic is (mostly) true, but last I checked the ASX 200 was still below 2007 levels – 13 years is a long time for prices to go nowhere if you go all-in at the wrong time. I’m assuming you are still reading because you don’t want to wait that long.

What could bring markets back to reality?

I don’t know. So far the following have failed:

  • terrible Q1 earnings and falling outlook
  • a failure to control the virus in the US
  • rampant virus activity in developing countries 
  • the likely intensification of the US/China trade war 
  • widespread rioting in the US

My best guess is a mix of bankruptcies and weak earnings will eventually do it. It might take six months. It might take six minutes.

A Biden win in the US has the potential to shock the market with higher taxes and wages. I expect this will actually be good for profits in the long term, but it might be enough to shock the market back to reality in the short term.

The danger for investors who have a plan to “run with the herd” and then sell when the market turns is that there seem to be a lot of other investors with a similar strategy. And given markets have set records for the speed of both downward and upward movements, you will want to very confident of your ability to get out at the right time. 

What about central bank support?

The arguments are:

  • Central bank liquidity will overwhelm insolvency risks.
  • Government stimulus overwhelms the economic damage.

It is not a particularly nuanced argument. Central banks will buy or fund everything. If our defensive position is wrong, this is probably going to be why.

Dig a little deeper, and the argument is less convincing. Governments and central banks have a choice:

  • take more pain earlier and recover faster
  • delay the pain and have a much more drawn out recovery 

Governments and central banks are opting for the second. Which means investors are going to have a lot longer to wait for company profits to recover. 

Can central banks and governments prop up failing large companies?

They can and will.

There is a slight question about how long for. However, the reaction to pretty much every debt crisis since Japan in the 1990s has been to prop up zombie companies. I think the plan is that if you give these companies enough low-interest debt then you can see out your term and leave any problems to your successor.  

I expect zombie companies to proliferate. Companies with such enormous debt burdens and low profits that they have little hope of ever paying off the debt. Which means the recovery will take longer.

Can central banks and governments prop up failing small and medium businesses?

These companies make up 50-70% of most economies. They don’t have listed debt that central banks can buy. 

It is extremely hard to prop up small businesses. The fraud risks are too high. Take a loan, transfer your assets into your wife’s name, pay your brother-in-law for some fit-out, declare bankruptcy. 

The Australian government tried to support small and medium businesses by offering partial loan guarantees for up to $40b of bank lending. The actual amount of credit looks like it will be closer to $4b – i.e. 90% lower than announced.

It is hard to support this part of the economy. I’m yet to see a proposal anywhere which looks workable.

Can central banks and governments continue to pay people not to work?

Yes. The question is how long for. Many governments put in place short term measures to support earnings for displaced workers. Most plans tail off over the next six months. 

In most developed countries the virus is now contained enough that hospitals are not over-run. Which means economies are at the stage where the imperative will become finding people new jobs rather than paying them not to do their old jobs. 

Will we see governments continue to pay elevated unemployment benefits to displaced workers for years? Possibly, but this once again, this will delay any recovery.  

Concern 1: Lack of consumer demand. 

Before Covid-19, even though consumers had been growing debt faster than income for years, consumer demand was still weak. Now consumers have lost jobs in record numbers, have been locked at home, face threats of future lockdowns and banks are tightening lending criteria. All the evidence so far suggests that it will be a long time before consumer demand returns. 

An often-cited argument is there will be pent up demand from people stuck at home unable to spend money. This is a rich person’s argument:

There will definitely be winners. But the impact of a few winners spending more money will be drowned out by the legion of people with less money. And rich people won’t be able to spend on travel for some time. And there will be winners who decide to save money in case there is a second wave.

Concern 2: Debt Crises 

Consumer debt is close to record highs. Corporate debt in the US is at cyclical highs. Add in weak consumer demand and supply shocks. All the conditions are present for a debt crisis. 

The best argument is that central banks and governments will “do something” when it becomes an issue. They might. I have no idea what, but it would be hugely expensive and incredibly prone to fraud. Effectively it would be suspending capitalism.   

Concern 3: Corporate Earnings and Valuation.

On top of the above problems, I see companies:

  • running lower debt levels
  • adding more redundancy into systems
  • adding more fat into supply chains
  • diversifying supply chains away from China. 

All of these will reduce earnings even further. And I’m not talking about the one-off impact this year, I’m talking about a long term decrease in earnings potential.

Earnings are cratering. Australian forward valuations have never been this high. US valuations were only higher during the tech wreck. 

Upshot    

The numbers are messed up at the moment. Growth rates are so large in both directions that they are virtually meaningless. The focus for investors should be on where earnings can get back to over the next few years. And I’m struggling to find anyone with a credible earnings scenario that would justify paying current prices.

I’m betting central banks and governments won’t suspend capitalism forever. 

There were a lot of superannuation funds and investors who completely missed the virus coming and rode the stock market all the way down and then most of the way back. They have been gifted a second opportunity to sell. My bet is very few will take the opportunity.    

———————————————

Damien Klassen is Head of Investments at the Macrobusiness Fund, which is powered by Nucleus Wealth.

Follow @DamienKlassen on Twitter or Linked In

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Nucleus Advice Pty Ltd – AFSL 515796.

Follow me

Comments

  1. Good article.

    One question though, the last line suggests most wont sell. Doesn’t that also mean prices won’t fall far?

  2. Damien KlassenMEMBER

    Nah. What I’m saying is that there are a lot of super funds and fund managers who are just “along for the ride”. They will give great explanations of market movements in hindsight but never do anything to pre-empt. They don’t drive markets because they rarely make changes.

  3. Good article
    One thing – the ASX is certainly way above 2007 levels when you account for dividends (i.e. use the accumulated index).

  4. darklydrawlMEMBER

    Thank you Damien. Articles like these make the subscription worthwhile. Great stuff.

  5. Thanks for the transcript Damien. Very useful refresher to read after listening to the podcast. Helpful

  6. Mr Market is on a crack bender at the moment.
    Crack benders are fun for a while but have a habit of ending badly.

  7. Goldstandard1MEMBER

    Looks like your timing was right Damien. I sold out completely yesterday as I only had the stocks that had already dropped heavily from February. Made back about 80% of the paper lasses so I’m happy with that.
    Nice one.

  8. The90kwbeastMEMBER

    Damien, great analysis & article as always.

    But, some humble pie needs to be consumed in the May 20 performance report because the MB foundation fund was positioned to miss most of the Apr & May stock market rally. The fund is so conservatively positioned that any downside risk is minimal anyway. I suggested for example 2 months ago that some careful buy the dip opportunities should have been taken, and they weren’t. So you say its a good opportunity to sell stocks now, but there really is none to sell in the MB fund because the weightings are already maximised to bonds & cash?

    I am also far more convinced than you on the power of the central banks. You guys were totally blindsided by one of the biggest stock market rallies in history from massive government stimulus and re-introduction of ZIRP, and have presumably wrote this article to placate the perma-bears that frequent this website and probably your fund.

    For 8 years MB, when it gets things wrong, forgets over & again the impact of governments on markets. The stock market is a manipulated market, and is not a free market. Ergo, it will drift in the direction now dictated by government & central bank policy, albeit with increased volatility.

    My 2c – the most likely outcome from here is a 10-15% technical correction back to, say for the S&P, 2,800 ish as the market has gone way too far too soon. Then everyone will remember that you get 0.25% in the bank, and the fed reserve is going to buy up everything anyway so back to the races after that.

    • Government’s can manipulate until they can’t.There comes a point where they can no longer (such as a pandemic in an excessively endebted world).They tried in the great depression as well with this policy and that(including underwriting the banks) but it just didn’t work.It needed to be worked through over time with a subsequent reset in outlook and expectations.Your attitude works mostly until it doesn’t

      • The90kwbeastMEMBER

        Yep, and here we are a decade later since the start of stimulus and still truckin’

        Gotta play the cards as they fall not where you hope them to land.

        • And I have .Just a warning one day it’s not going to work(and I suspect that day is upon us)

    • There was mega bailout during the GFC too, but downside was definitely not limited so soon after market top.

  9. graphicMEMBER

    With the US accounting for half the world’s stock market value, it all depends on the US. There’s just no good news for the US market in sight until the end of the year: Q2 earnings reports in July will be a disaster, the Covid death numbers keep rising and Biden looks more likely to win with every crazy Trump tweet.

    The only interesting thing is whether Asian stock markets can decouple from the US market. Yes, there’s a lot of debt in Asia too, but Covid is under control and there’s no political turmoil.

  10. DominicMEMBER

    Really enjoyed that, Damien, thanks. The only comment I’m sceptical of is this one:

    “I’m betting central banks and governments won’t suspend capitalism forever.”

    There is no doubt the right thing to do is to let the market take its medicine and for the heinous amount malinvestment to be purged, but central banks have exhibited a desire to not allow this process to happen (they have consistently built bridges across the troubled periods) and the more you don’t, the more you can’t. The time to take the pain was back in ’98 and ’01 and ’07 and ’12 and so on. Right now we’ve accumulated enough fuel to level the global economy.

    Allowing capitalism (and market prices) to reassert itself is politically untenable so it won’t happen – “not on my watch” applies to pollies and central bankers alike. I believe they will continue to pump the patient full of drugs until the drugs kill the patient – better to kick the can and hope for the best than know for sure what the outcome will be if you stop.