Since the recent low of 2237.40 registered on March 23, the S&P 500 index has staged a major counter-trend rally gain of 24.69%, as of April 9. This includes a gain of 11.23% in the past week. Although there were several technical factors and news catalysts that have contributed to this massive counter-trend rally, perhaps the most important critical factor has been expectations and announcements regarding unprecedented measures by the US Treasury and the US Federal Reserve to inject massive amounts of fiscal and monetary stimulus into the US economy and financial markets.
In this article I will explain why the combined measures by the US Treasury and Fed will not be enough to prevent massive and long-lasting losses of national income, production and wealth. In particular, I will show that in the context of their inability to prevent a massive and prolonged economic crisis that will extend well into 2021, US Treasury and Fed stimulus measures will not ultimately prevent the occurrence of another massive leg down in US equities. Indeed, after the current counter-trend rally fizzles out and the primary bear market trend resumes, in the course of the next leg down, US equity prices will collapse significantly below recent lows and establish a bottom somewhere between the range of approximately 1900 and 1500 on the S&P 500 index. The eventual recovery from this intermediate-term bottom will most likely be prolonged and painful (as opposed to V-shaped), with potential – depending on various developments – for occurrence of yet another major leg down to even lower levels.
The Economic Backdrop
The Unites States is barely in the initial stages of one of the most devastating economic crises in the nation’s history. Certainly, the forthcoming economic crisis will the most severe since the Great Depression.
After initially underestimating the severity of the crisis, economists at Goldman Sachs, Bank of America, Morgan Stanley and JPMorgan now all agree (several weeks after I had published my own forecasts) that the contraction in US GDP in the second quarter of 2020 will be in the order of 30%-40% – by far the largest quarterly contraction in US economic history, including the Great Depression.
In this context of this economic crisis, unemployment is expected to peak at 20%-30% while business bankruptcies skyrocket to unprecedented levels.
Economists currently disagree on the timing of the economic recovery and regarding how quickly the US economy will be able to re-achieve prior levels output and employment.
My own estimates is that the US will not reach prior peak levels of output until the fourth quarter of 2021, at the earliest. Most worryingly, due to lasting damage to the economy, full employment may not be reached until 2030, or beyond.
Stimulus Measures Announced to Address the Crisis
On Thursday, the US Fed announced an emergency package worth up to $2.3 trillion. The package is extremely broad, encompassing credits to aid small and mid-sized businesses, loans to state and local governments and purchases of some types of high-yield bonds, collateralized loan obligations and commercial mortgage-backed securities. The following is a summary of some of key details:
- The Main Street Lending Program will “ensure credit flows to small and mid-sized businesses with the purchase of up to $600 billion in loans.”
- The Municipal Liquidity Facility will offer as much as $500 billion in lending to states and municipalities.
- The expanded Primary and Secondary Market Corporate Credit Facilities and the Term Asset-Backed Securities Loan Facility will support as much as $850 billion in credit.
- Expansion scope of securities purchasing programs to enable purchase of various types of debt securities and investment instruments such as corporate bonds of “fallen angels,” high-yield bond ETFs and others.
- The Fed will start funding the Paycheck Protection Program Liquidity Facility, “supplying liquidity to participating financial institutions through term financing backed by PPP loans to small businesses.”
The programs that were announced greatly expanded the scope and breadth of the Fed’s efforts to intervene in support of businesses and credit markets. Both the quantity and the manner of the program were expected as they already had been announced.
None of these measures come as a surprise to me. I have fully expected that both the Treasury and Fed would take unprecedented actions to mitigate the damage from the most devastating economic crisis since the Great Depression.
Indeed, in the days, weeks and months ahead, I expect many more announcements of massive rescue programs involving trillions directed at virtually every area of the economy.
However, as I will proceed to explain, none of these measures individually, or in combination, will be enough to prevent a very deep and prolonged economic crisis. In particular, these measures will not be sufficient to prevent the occurrence of another massive decline in US equity prices, in which causes the value of the S&P 500 index to collapse substantially below the short-term low of 2237 recorded on March 23, 2020.
Reasons Why Fiscal and Monetary Stimulus Will Not Be Enough
Due to space constraints, in this article I will merely outline a few of the most important reasons why fiscal and monetary stimulus will not be enough to prevent a deep and prolonged economic crisis and an associated “second leg down” in the ongoing bear market in US equities. I will organize the presentation around the inability of fiscal and monetary stimulus measures to prevent: 1) Severe and prolonged losses of income (individual and business), 2) Acute and long-lasting losses of production, 3) Massive long-term losses of wealth.
Loss of Income
Despite the many programs designed to mitigate losses of income, enormous losses of income by individuals and businesses will go uncompensated. The macroeconomic importance of this is that drastic losses of income will translate into similarly drastic reductions of expenditures on goods and services in the economy.
Loss of Individual Income
Despite government efforts the aggregate personal income of Americans – even after government aid is accounted for – will suffer enormous losses.
- Loss of income due to unemployment. The salaries and wages of unemployed people will not be completely compensated by unemployment insurance. Although it’s true that some workers may end up receiving more money than they previously earned, on average, unemployed workers will experience a substantial decline in their personal income.
- Loss of income due to fewer hours worked. Even among the cohort of the citizenry will not become unemployed, Americans on aggregate, will suffer significant losses of income due to the reduction of regular hours worked and the decrease of overtime hours worked.
- Reductions of salaries and wages. Many firms will cut salaries and wages to avoid losses and even to avert potential insolvency. In this context, it’s important to note that the federal government’s CARES Paycheck Protection Program, which is designed to keep workers on company payrolls via conditional loans that are potentially forgivable, allows companies to cut worker wages and salaries by up to 25%, without forfeiting eligibility for forgiveness of the loan. It’s therefore to be expected that many firms receiving federal benefits will indeed cut wages by up to 25%. Furthermore, wage cuts of greater than 25% can be certainly be expected at the huge number of firms that do not qualify for the forgivable loans under the CARES Act. In this context, it’s important to note that a very large percentage of US firms of all sizes will not qualify for forgivable loans and will therefore face no restrictions in terms of reducing wages and salaries by extremely large amounts.
- Loss of tips, commissions, bonuses and incentive-based compensation. Large amounts of the incomes of US workers is earned in the forms of tips, commissions, bonuses and various forms of incentive-based compensation. At the vast majority of US firms, these forms of compensation will be radically cut and eliminated during 2020. These categories of worker pay will clearly not be compensated by Fed and Treasury stimulus programs. The drastic reductions in these forms of income will have a very large negative impact on US aggregate income.
In sum, there will be massive losses of income to both unemployed and employed individuals in the US throughout 2020, 2021 and beyond. These drastic losses of income will translate into drastic losses of expenditure on goods and services in the economy.
In terms of how this impacts the market value of US equities there are two main effects. The first and most important effect is via the reduction of personal expenditures and the concomitant reduction in US corporate revenues and earnings. The second effect occurs via the impact of reduced income on the propensity to purchase equities (directly or via funds). Individuals who have experienced large losses of income (of fear that they might) are generally not able or inclined to spend or risk scarce cash on stocks – particularly in an environment characterized by the enormous and very frightening types of economic and financial uncertainties that will tend to characterize the US and global economic landscape in the COVID-19 and post COVID-19 era.
Loss of Business Income
Loss of business income in the US economy will be even more drastic in percentage terms than the loss of income by workers. Although Fed and Treasury stimulus programs can certainly mitigate losses of business income to a limited extent, firms and their owners will nonetheless face drastic reductions in their incomes during 2020 and 2021 (relative to 2019) that will be uncompensated by government programs.
- Loss of income by large companies and owners. For example, I estimate that the earnings per share of US publicly-listed companies will decline by no less than 50% on a year-over-year basis in 2020. Indeed, I believe that it is likely that earnings per share of US publicly-listed companies and private companies are likely to be negative on a cumulative basis for the last three quarters of 2020. As a result of the drastic decline in company incomes, dividends to owners also will suffer massive declines.
- Loss of income by small companies and owners. Small businesses are disproportionally represented in the areas of the economy that will be hardest hit by the COVID-19 epidemic. To make matters worse, profit margins and financial flexibility is far lower for US small businesses compared to large businesses. Therefore, on aggregate, US small businesses and small business owners are likely to experience net reductions of income on a cumulative basis during 2020 and 2021 (relative to 2019) that are even greater in proportional terms than that of larger firms.
The above types and magnitudes of losses for large and small companies will occur despite the enormous rescue packages by the Treasury and Fed. This will occur for three reasons.
- Many firms not qualified. Many businesses simply will not qualify for government assistance programs.
- Assistance will not be sufficient to prevent reduction of income. In the case of many businesses that do qualify for government assistance, the programs will not be sufficient to prevent large reductions in their net income. Indeed, many firms will experience large losses despite receiving government assistance.
- Assistance will not prevent business failures. Many businesses that qualify for assistance will simply choose to shut down operations (partly or entirely) causing large reductions of income – as opposed to continuing to operate in the face of potentially generating even larger losses and/or increased indebtedness. For example, not all forms of assistance will be forgivable (meaning it has to be repaid) so many companies will prefer to shut down their operations rather than be saddled with large quantities of debt that the companies will not (or may not) be able to be repay. Furthermore, many businesses that qualify for forgivable loans will nonetheless elect to shut down their operations, in cases in which their owners/operators forecast (or fear) large losses, despite government assistance.
Since business income represents a substantial portion of total income in the US economy, massive reductions of business income will have a profoundly negative impact on the US economy with destructive ripple effects throughout the entire economy. Drastic losses of business income by companies will result in massive declines in ordinary business expenditures (e.g. payroll and supplies) and even more drastic declines in capital investment expenditures.
Although Treasury and Fed stimulus programs will substantially mitigate losses of business income relative to what would have occurred without such assistance, US businesses – both large and small will nonetheless sustain massive losses of income.
Drastic declines in aggregate business incomes in the US economy impact the market value of US equities in two main ways. First, the reduction of business income of US firms means drastically lower profitability of US publicly-traded companies. Lower net earnings and profitability impacts both the intrinsic and perceived value of US firms, thereby negatively impacting the prices of their shares in the stock market. Second, the reduction of business income of US firms lowers their capacity and propensity to buy back their own shares. This is important because stock repurchases by companies of their own shares has in the past decade has represented, by far, the largest single source of net demand for US equity shares – indeed greater than all other sources combined. In this regard, Goldman Sachs has recently published a study in which it’s estimated that stock buybacks by US publicly-traded firms will be slashed by one half compared to 2019 levels. My own firm forecasts show even deeper and more widespread reductions in the amount of share purchases – on the order of -70%.
In addition to the drastic reduction of business and personal income there will be another factor that will drive a massive contraction in spending in the US economy: Increased savings. Out of every dollar received by US individuals and businesses from ordinary sources of income or via government transfers, they will spend a lower-than-normal fraction of it and save a larger-than-normal fraction of it. When firms and individuals save an increased proportion of their income (including government transfers), the total amount of expenditure in the economy – and concomitantly the total amount of income in the economy – is reduced roughly in proportion to the amount of the increase in savings.
Savings by individuals and firms will increase for at least three reasons:
- Increase in precautionary savings. Frightened consumers and businesses will cut back on spending to save for foreseen and/or unforeseen contingencies.
- Fewer things to spend on. Social distancing necessarily means that people will have far fewer things to spend money on (no concerts, no sporting events, no restaurants/bars/nightclubs, no vacations).
- Reduced use of credit for growth of expenditure. Net savings will increase (and net expenditures will decrease) via the reduced usage of credit used by individuals and firms to grow their expenditures and/or their output. Although many individuals and/or businesses actually will increase use of credit to compensate for lost income, relatively few firms and individuals will make use of credit to grow their level of expenditure. To the contrary, firms and businesses will generally tend to drastically reduce their usage of credit for discretionary spending on non-essential expenditures and investments, thereby causing an overall reduction in the level of expenditures and income in the economy.
While the Fed and Treasury can somewhat mitigate the precautionary motive for savings, they cannot prevent an overall increase in the propensity to save. First, Fed and Treasury measures will not prevent individuals and firms from curtailing savings for precautionary reasons. Second, they cannot provide consumers with opportunities to spend which compensate for the opportunities to spend which have become unavailable. Finally, the Fed and Treasury cannot force consumers and businesses to increase their use of credit to increase their expenditures relative to 2019 (as opposed to using credit to merely compensate for lost income).
To sum up this section on loss of income, while the Fed and Treasury can mitigate losses of income by businesses and individuals to some extent, they will not be able to compensate for all of the losses of income that will occur. In terms of how this impacts aggregate economic statistics, if there are overall losses of personal income plus business income (including government assistance) equaling around 20% of total national income in the next three quarters of 2020 (with peak losses of over 30% in the second quarter), Gross Domestic Income will decline by a similar amount during that period. Furthermore, a reduced propensity to utilize and issue credit will only exacerbate the reduction of expenditures (and concomitant aggregate income) in the overall economy
Loss of Production
The Fed and Treasury can distribute all the money they want to individuals and firms. However, they cannot prevent enormous losses of production that will occur during the course of this crisis. Production will be reduced for various reasons including the following key scenarios, among others.
- Mandated and voluntary social distancing constrain production. Many firms will shut down or reduce production – due to legal restrictions or due to voluntary measures – in order to contain the spread of the COVID-19 virus.
- Global supply chain disruption. Many firms will shut down or reduce production due to global and domestic supply-chain disruptions.
- Loss of demand. Many firms will shut down or reduce their production in response to loss of demand. For example, production at restaurants, entertainment venues and many other sorts of businesses will shut down or be reduced due to the fact that customers will voluntarily restrain themselves from consuming products or services when doing so is perceived to place them at a higher risk of COVID-19 infection. Furthermore, demand will be lost simply due to the drastic reduction in income suffered on the part of consumers and businesses.
Massive losses of production will be occurring for all of these reasons until an effective vaccine is widely available – something that is not expected for another 18 months at least (if it can be developed at all). If overall production of goods and services declines by about 25% in the next three quarters of 2020 (with a peak loss of about 40% in the second quarter), then Gross Domestic Product will decline by roughly 25% during that period.
Loss of wealth
The following are just three ways in which wealth will be massively destroyed in the US economy.
- Destruction in the value of equity. There will be a massive destruction of the wealth of the equity of business owners for reasons that I described in considerable detail in my most recent article. In sum, insolvency, restructuring and recapitalizations will decimate the equity value of most business owners. Furthermore, there will be large reductions in the long-term intrinsic value and market value over owners’ equity due to the reduced long-term growth rates and higher long-term discount rates that will result from this crisis.
- Destruction in the value of debt. Debt holders and creditors of all sorts will suffer massive losses of wealth due to the reduction in the intrinsic value and market value of their debt holdings. Massive quantities of defaults and greatly increased default risk on the part of many debtors will cause massive losses in the intrinsic value and market value of debt, leading to a massive loss of wealth on the part of creditors (with out a corresponding increase in wealth on the part of debtors).
- Destruction in the value of real property. Due to loss of demand for property and loss of income by renters/leaseholders, there will be massive destruction of wealth for real property owners.
How does the massive destruction of wealth in various forms impact the real economy? Wealth destruction will reduce the level of expenditure in the economy for two main reasons. First, wealth destruction reduces the propensity to spend in the economy by both consumers and businesses that have lost wealth – both on consumer and investment goods. Second, wealth destruction reduces credit worthiness, credit capacity and the willingness to both issue and take out credit on the part of consumers and businesses. This lowers the level of current and future growth by inhibiting both investment and consumption expenditures by businesses and consumers.
Fed Cannot Prevent Massive Insolvencies
While Treasury and Fed programs can and will alleviate liquidity problems at many companies, these programs will not be able to address the fundamental solvency problems at many companies that will result in long-term destruction of production, incomes and wealth.
Let us just take a few examples:
- Establishments such as restaurants, bars and night clubs will be devastated by mandated and voluntary “social distancing” measures. Many of these firms will simply shut down. And even assuming that a vaccine is widely distributed in 18 months it will take many years for the former level of activity (and income) in these industries to return to previous levels. This is due to the fact that many former owners and operators of these businesses will be financially devastated and will be either reluctant to get back into business or incapable of doing so due to loss of wealth and credit restrictions.
- Brick and mortar retail. Any business that relies on large numbers of people gathering in limited spaces will not be viable and will face insolvency. For example, high-traffic stores and shopping malls will see massive reductions in business even after mandated lockdowns are eased. This is due to voluntary social distancing. Due to competition from e-commerce, many of these businesses were barely viable before the COVID-19 crisis and were undergoing a slow “retail apocalypse.” In this context, and in the forthcoming era of prolonged social distancing (both mandated and voluntary), a huge proportion of these businesses will simply not be coming back.
- Theme parks, live entertainment events, conventions. These businesses will essentially have to remain shut down at least until a vaccine/cure for COVID-19 is found. This will most likely not happen for at least 18 months. And even then, it may take a long time for these businesses to resume production at former levels given the fact that many operators of these businesses will be financially ruined.
The types of businesses described above do not have a liquidity problem. They have a solvency problem. And so do all of the people that serve these businesses – their suppliers, lawyers, accountants, etc. No amount of government assistance or loans will reactivate lost production and lost income and lost wealth caused by the destruction of these firms.
These businesses are a major part of the economy and employ huge numbers of people. As mentioned previously, after the need for social distancing dissipates, many unemployed owners and workers will be fortunate enough to find employment in their former industries. However, it will take a long time for these industries to ramp back up to their new equilibrium levels of production. Perhaps even more importantly, many of these industries will never return to their former levels of employment, and a many workers in these industries will not be able to return to their old jobs.
It’s not an easy matter to retrain workers for new jobs. And it’s certainly not an easy matter for entirely new industries to emerge that will employ the vast numbers of people that are left unemployed for large periods of time. The upshot of this is that long-term unemployment will be part of the American economic and social landscape for many years.
There’s very little that the Treasury or Fed can do to prevent the massive levels of long-term unemployment that will be caused by this crisis. Furthermore, there’s very little that the Fed and Treasury can do to compensate for the massive losses of wealth suffered by owners and workers in these industries.
There’s No Free Lunch
Almost forgotten in the midst of all of the excitement surrounding government stimulus is a fact that should be obvious: There’s no free lunch. The Fed can finance the US Treasury and US businesses all it wants. This will not change the fact that there will have been an enormous increase in debt in both the public and private sector without any corresponding increase in production and/or productivity in the economy. The addition of a such a huge debt burden (without any corresponding increase in productive capacity) will necessarily cause a huge loss of future production and/or national wealth.
The massive increases in public and private debt brought about by this crisis will ultimately be paid for in two ways – most probably in both ways: 1) Lower future growth. 2) Higher inflation.
High debt lowers future growth by increasing interest burdens, increasing solvency risks and limiting future credit capacity. All of this reduces future potential investment and consumption.
Furthermore, the increase in the enormous levels of debt increases the risk that this will be “paid for” in the future via increased levels of inflation. The problem is that inflation is no free lunch. Although inflation reduces the real value of accumulated debt and makes repayment of debt with fixed interest costs easier, inflation also imposes many costs on the economy and many constraints on future growth.
First, the instability of prices lowers investment since the ability of entrepreneurs and producers to plan the cost of inputs and outputs is reduced. Second, credit costs increase as interest rates rise, thereby impacting both the issuance and taking of credit. Finally, inflation has adverse distributional effects in the economy such as lowering real wages and thereby lowering real consumption, living standards and wealth.
Some people evidently think that the US government can just throw money at the problems caused by this economic crisis and repair the vast damage done such that the net impact on the value of US equities is relatively minor. These people are mistaken. The money thrown at these problems will come with a high price tag in the form of higher levels of debt and higher long-term inflation and/or long-term inflation risks which will significantly impact both future growth and the discount rate at which the future cash flows of equities will be discounted.
Many people seem to assume that massive US Treasury and US Fed stimulus programs will essentially “make up” for all of the economic damage that has been done by the COVID-19 crisis. As I have shown in this article, this is simply not the case. Although Treasury and Fed programs will certainly mitigate many problems it will not come close to compensating for all of the losses of income, production and wealth that will occur. These uncompensated and essentially “unfixable” gaps represent an enormous proportion of the US economy that employs an enormous number of people. The implication of this is that the forthcoming economic crisis will not only be extremely deep but very prolonged in time. Long after the economy is “opened up” and “lock-down” measures are eased, many industries that employ huge numbers of workers will remain devastated.
The devastation in many industries will only really begin to be remedied in earnest approximately 18 months from now – if and when an effective vaccine and/or cure is developed and made widely available. And even after that occurs it will take substantial amount of time for business in devastated industries to reemerge (often with new owners) and for many long-term unemployed people to be re-trained and re-employed in other occupations.
Therefore, there will be no V-shaped recovery of the US economy. The forthcoming recession will be both deep and prolonged. And no amount of Fed and Treasury stimulus can fundamentally alter this inevitable fact. Fed and Treasury stimulus can ameliorate the damage that otherwise would have occurred to the economy. However, they cannot prevent massive business closings, massive unemployment and massive losses of income, production and wealth that will inevitably occur as a result of this crisis. And when economists, investors and the general public finally come to understand this, the current bear market rally will become aborted and the next leg down in US equities will begin.
A reversal of the current bear market rally and a collapse to significant new lows will happen sooner rather than later. It’s important that you devise and quickly implement a portfolio strategy that is designed to deal with this forthcoming collapse in US equity prices and its aftermath.
It is critically important that you have a portfolio strategy that is properly designed to deal with the forthcoming unprecedented economic crisis — and its aftermath. Subscribers of Successful Portfolio Strategy are ready to both manage the risks and capitalize on the opportunities that will be presented in these unprecedented times. Our service empowers you with knowledge and tools needed to implement a winning portfolio strategy.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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