With the news changing hourly, I’ve spent a ton of time over the past several days trying to think through what this might mean as an investor, an employee, and an American. In this article, we’ll talk about where the economy was before the outbreak, probabilities for the economy going forward, and some advice for navigating the coming changes.
The economy was on fragile footing prior to the virus. The virus was not the cause, but rather the pin that pricked the bubble.
The Impact of the Last Market Crash
To understand why, we have to go all the way back to the housing crisis in the late 2000s. The response from the Federal Reserve and the U.S. government was to intervene significantly in the market.
By injecting massive amounts of liquidity and driving interest rates to artificially low levels and keeping them there for a decade, it prohibited the economy from truly healing. This caused resources to be locked up in less efficient areas of the economy, rather than being liquidated and put in the hands of the businesses and consumers who would put those resources to their best use.
Recessions, for all of the pain that they cause, do serve an important function. That function is to redistribute resources away from the inefficient areas and back to their best use. By providing cheap credit and propping up prices, this couldn’t occur the last time around. Instead, we had many “zombie” firms, only kept alive by cheap borrowing costs.
We also re-inflated housing prices back to levels at or above their peak. This helped people who had owned houses, but it hurt those trying to buy a house and needing to dedicate more of their income and savings to the task.
The artificially low interest rates also reshaped our economy in meaningful ways.
Savers and retirees got hurt, as they couldn’t put their nest egg into anything other than stocks if they wanted to beat inflation. Someone that did all of the right things in life and saved $500,000 for retirement could have earned 5 to 6 percent in a savings account or CD in the ’90s. That $25 to $30 grand, plus social security, plus a gradual draw-down of the principal could provide a pretty comfortable retirement.
But with interest rates at 0 percent, they had no choice but to put their money at greater risk to try to get returns to live on.
Low rates also drive up the valuation of other financial assets. When treasury rates are low and the Fed is creating massive amounts of base currency that needs a home, investors bid up the assets of everything from stocks to bonds to real estate to artwork.
Firms use the artificially low rates to issue debt. The proceeds are used to buy back stock and pay dividends. The result is weaker balance sheets and greater credit risk in the economy. Debt service is reliant on continued strong cash flow with little balance sheet strength as a backstop.
The economy did recover, but many people felt left behind. Many of the jobs created weren’t of the same quality or earnings potential.
Federal reserve policy enabled those already wealthy enough to hold financial assets to reap the benefits of the surge in prices, while average people did not participate. This led to some social unrest as this “wealth gap” persisted.
The State of the Economy Pre-Virus
Now bring it back to February 2020. Here’s what we had: A highly leveraged economy—corporate debt as a percentage of GDP was driven to the highest levels in history. They’re only able to service this debt thanks to the very low interest rate and strong earnings.
However, with tight unemployment driving wage gains:
And those wage gains put pressure on earnings:
Thus, broader economic activity began cycling downward:
We were already in a fragile situation. However, my base case was for an elevated possibility of recession, but I did think we’d likely hold it off for a while longer. The foundation of this theory was continual strong consumer confidence, no sign of employment faltering, and some modest improvement in the manufacturing ISM survey.
The stock market (along with bonds and real estate) was carrying values last seen in 1929 and 2000. For a good understanding of the obscene valuation in the stock market, I recommend John Hussman’s market comments located here.
For my money, Hussman is one of the absolute best at articulating this viewpoint and backing it up with solid facts. Below you’ll find his chart, pre-virus, of a metric he calls the “Margin Adjusted Price to Earnings Ratio.” Check out his market comments for a fuller explanation.
For our purposes, it’s sufficient to understand that this metric reflects the long-term, inflation-adjusted earnings of a stock, and adjusts it further to normalize profit margins, which tend to be mean reverting. High profit margins can make valuations look less crazy than they are.
This metric has about an 89 percent correlation with future returns on a 12-year time horizon. As seen below, at least with this metric, the stock market was overvalued to an even greater extent than the dot com bubble or the 1929 peak. The recent pullback has likely put this metric somewhere in the low- to mid-30s—still quite high from a historical perspective.
The Economic Fallout From Coronavirus
Coronavirus/COVID-19 hitting the scene was bad enough on its own. People’s reactions exacerbated the problem further. It also served as a wake-up call to investors to see just how frothy the financial markets were.
Then we had mass cancellation of events and people have pulled back drastically. Restaurants and hotels are empty. Port volumes are way down. International supply chains with their origins in China have been severely impacted. U.S. supply chains may now be in question, as well.
We won’t have hard numbers to confirm anything for quite some time. Data will trickle in gradually, starting in April with ISM survey data and payroll data. The full picture of GDP will be further off.
At this point, there are simply more questions than answers.
My base case is now that a recession has unofficially started. How that ultimately looks is still up in the air. We may see a quarter or two of sluggishness, followed by a nice recovery. We also may see this kick off a credit crisis due to the highly leveraged corporate economy, which could then lead to borrowing problems and further layoffs.
A lot will depend on the next several weeks and how events unfold.
What Moves Should Investors Make?
I don’t know. Plotting a definitive course of action in times of flux is impossible. Here are some of my thoughts:
- Look for opportunities. In every recession, fortunes are made by those with the foresight and courage to find opportunities and take action.
- Don’t panic. Cooler heads will prevail here. While flawed, we still lived in the greatest economy ever known to mankind. We will bounce back over time—stronger than ever. Do what you can to save a few months of living expenses. Make yourself invaluable to your employer. Start thinking of innovative ways to solve problems.
- Don’t succumb to fear. Be bold and take charge of your future. Make smart choices, but have the courage to live your life with the proper precautions. Don’t wallow in pity. The situation is what it is. Ask yourself, “What now?” Make a plan and execute.
- Resist the urge to look to the government for salvation. Strong, focused, local action beats one-size-fits-all approaches every time. Don’t give up your sovereignty over yourself due to fear. Keep an eye on those who would seize power and control in a crisis. Resist the urge to politicize this thing and start slinging mud.
- Let markets function. Resist the urge to demonize “price gouging.” Higher prices reflect scarcity and are a necessary signal to producers and consumers. If toilet paper prices went to $40 per package, consumers would only buy what they absolutely needed, and there’d be some left on the shelf for the next guy. Forcing prices to stay low only benefits whoever is lucky enough to get to the store first.
- Stop buying toilet paper—for the love of Pete. I’m about to create a makeshift bidet out of a garden hose.
- Support each other. Check in with your neighbors and friends. Share what you have with those in need. If hospitals get as bad as some say they are going to get, we’re going to need to pull together in a big way to mitigate the damage. If you’ve got doctors and nurses in your community, start planning to help them now. Bring their family meals. Offer to take their kids in so they can go to work. Find the pain points in your community and find ways to alleviate them.
- Go donate blood. The country is in dire need.
- If you bought a hoard of N95 masks, take them to the nearest hospital. Now. Every one of them. You can literally save someone’s life. Do it now. Please.
If history is any guide, we are about to see some true heroes in action in the coming weeks. It’s in our DNA. I expect to see doctors, nurses, business owners, and citizens make great sacrifices and put themselves in harm’s way to save others.
We’re in a fight right now, plain and simple. It’s a fight we’re going to win.
If you get sick, or if you get laid off, or if your business is struggling, fight! Fight your way through it with every ounce of energy and passion you possess. When you feel like you can’t do it any longer, fight some more. Don’t ever give up.
With that, I’d ask all of you to join me in what I’d like to call the Corona Jubilee. This is an event that I’ve just now created on the fly while writing this.
Once we get the “all clear” to go out and socialize, let’s pour into the streets, into the bars, restaurants, local businesses, and hotels. Let’s make St. Patty’s day look like child’s play, as we celebrate our unbeatable resolve.
Let’s celebrate the fact that we will take on any challenge, defeat any enemy, and we will exercise our liberty and unity by sticking up a giant middle finger to this bug. I’ve just created a Facebook group. Search and join The Corona Jubilee to start organizing ideas. #CoronaJubilee.
We’re going to turn this tragedy into the greatest lesson we can teach our children and grandchildren. When times look dark, when our backs are against the wall, we pull together. We fight. And we win.
Join the discussion below.