Juggling Dynamite

While the tech and the precious metals sector have to date recovered sharply from the first leg of the 2020 market plunge, other more economically reflective sectors like financials, energy and real estate investment trusts are not feeling the same optimism and remain mired in a bear market.  See Blackstone to shutter real estate income fund for a taste of what’s unfolding.   As the Trump admin works daily to prop up the stock market as key to its re-election bid in November, a financial pandemic continues to undercut the real economy and national income.

Dick Bove spent decades as a US bank analyst and was traditionally very bullish on the sector. His new position as a strategist evidently affords him a wider scope to acknowledge downside risks and his comments on BNN this week offer some big picture insight on US banks and the economy.  Here is a direct video link.

An important caveat I would add:  while JP Morgan is widely considered ‘best of class’ in investment banks and Bove praises CEO Jamie Dimon, the bank’s share price remains 40% below its February high, and the giveback and write off part of this credit cycle is only just started.  A similar story is playing out for Canada’s ‘best in class’ banks.

One problem area is the share of mortgages newly delinquent.  The chart beside shows the US trend to the end of April and compared with the 2008 recession.

Even excluding approved mortgage loan deferrals for qualified borrowers, a US Census Bureau survey shows that as of June 30, about 8.4 million households had missed a mortgage payment in the past month and that was up from the end of April. The Mortgage Bankers Association reports 4.1 million households were in forbearance as of July 5.   Millions more who didn’t have a loan backed by the federal government weren’t eligible for the forbearance program and so some loans are going right into delinquency with more likely to follow when permitted deferral periods end.   See  An indicator that presaged the housing crisis is flashing red again.

Similar trends are evident in Canadian household loans, with deferral programs delaying and increasing the likelihood of insolvency filings for many households. Canadian insolvency trustee Doug Hoyes explains in Insolvency Predictions post-COVID-19:

Mortgage and payment deferrals will add to consumer credit balances post COVID-19.  The deferrals are beneficial to help individuals manage cash flow and help lenders manage delinquency rates but the end result is larger balances for longer.

With less ability to pay, many individuals will make partial payments on credit card debt and other obligations, resulting in growing rather than declining credit balances. Delinquencies will increase. While some credit card companies are offering to lower interest rates, interest will still accumulate on ever higher balances.

Worse, some consumers will manage the crisis by taking on more debt. What is worrying is that much of the borrowing will be in the form of high-interest subprime debt, including payday loans and high-interest financing loans. Heavily indebted consumers were already relying on these types of loans to make ends meet before the crisis, and they are increasingly likely to do so now. Alternative lenders will see higher delinquencies and losses in the short run but may offset this financially with massive loan growth.

…Payments through the government economic response programs like CERB will offset some of the demand for more credit and default rates. It is too soon to predict exactly how high insolvencies will rise, how quickly and for how long. However, we do know that Canadians will experience fallout from the heavy burden of debt they carried into this crisis and that the tail will be long.

Companies have also piled on debt during the pandemic, with global firms selling a record $2.1 trillion of bonds to investors this year and nearly half coming from U.S. issuers (Bloomberg data). With many highly indebted coming into the crisis, adding more debt now is imprudent for borrowers, lenders and investors and compounds insolvency prospects.  See:  Father of the z-score predicts a surge in ‘mega’ bankruptcies.

After plummeting between February 20 and March 23, the S&P 500 (below in white) rebounded sharply and is closing in on levels that prevailed at the start of this year. Unemployment meanwhile (inverted in red below), is over three times higher than it was before the Covid-19 outbreak and the highest in decades, as shown in this chart from Crescat Capital. The chart below from my partner Cory Venable shows a similar picture with US industrial production in blue since 2003 versus the wildly unhinged S&P 500 price in July (red line).

Bulls scream at times like these, “The economy is not the stock market stupid”. True, but textbooks confirm it’s supposed to be a leading indicator of the economy.  In recent cycles though, increasingly extreme plunge protection efforts by policymakers have succeeded in intermittently stalling the market’s mean reversion lower from nose-bleed levels.  Stalled, but not stopped, it must be said.  Stock prices have ended up catching down with real-world economic indicators each cycle eventually.  Oh, and profit margins too.  As shown in this other bothersome picture from Crescat Capital since 1989, estimated S&P 500 profit margins (in red) also have a signal to share about stock prices (white line) in the months ahead.  And it’s not bullish.

John Hussman’s July letter Fundamentally Unsound is worth the time.  If more people followed the simple math of how the price paid drives investment returns, fewer people would be sideswiped by financial disaster.  A security is just a claim on some set of expected future cash flows. The higher the price you pay, the lower the long-term return you can expect.  Hussman puts it in layperson’s language as follows:

Suppose that the $100 taped in the upper corner of the room will be delivered a decade from today, and you’re deciding how much to pay today for that future piece of paper.

Drop your hand toward the floor. If you pay $19 today for $100 a decade from now, you’ll earn 18% annually on your investment.

Raise your hand a little higher. If you pay $32, you’ll get 12% annually. Raise your hand above chest-level. If you pay $46, you’ll get 8%. Raise your hand to the top of your head. If you pay $67, you’ll get 4%. Now reach above your head. If you pay $82, you’ll get 2%. Jump in the air so your hand is even with the piece of paper. If you pay $100, you’ll get 0%. And if you’re aggressive enough to pay more than $100 today for that future $100 payment, you’ll get a negative return on your investment over the coming decade.

That’s the first rule of valuation. Given any set of future cash flows, the higher the price you pay today, the lower the long-term rate of return you can expect on your investment. Nothing about this relies on mean-reversion. It’s just arithmetic.

But don’t low interest rates justify overpaying for equities?  Nope…it’s dumb and dumber:

If someone tells you, “well, stock valuations are high, but high valuations are justified by low interest rates,” they’re actually arguing that passive investors face the worst of all possible worlds. They’re saying “well, future stock returns are likely to be dismal, but dismal returns on stocks are justified because you’re going to get dismal returns on bonds too.”

Saying that extreme stock market valuations are “justified” by low interest rates is like saying that poking yourself in the eye is “justified” by smashing your thumb with a hammer.

Worse, by our estimates, the likely 10-year total return of the S&P 500 from current valuations is about -1.4% annually.

So far, from bubble valuations in March 2000 to March 2020, the S&P 500 was able to squeeze out a nominal total return of 4.4% annually (assuming zero withdrawals or fees and perpetual reinvestment of every dividend received) only because prices rebounded to reclaim irrational valuation extremes that today match or exceed March 2000 levels.

The next leg of the bear market will reduce 20-year retrospective returns for present holders toward zero and set them up for years of just trying to grow back their capital.

Those who wait to buy when prices retreat, however, will be set up for years of above-average returns from there.  It’s just math.