First Liquidity, Then Solvency

By Lyn Alden Schwartzer:

Capital markets look like they're in the eye of a storm recently, with a period of calm after what was one of the most volatile periods in global market history. Does it get better from here, or is this a big fake-out for another round of selling as we move deeper into this year?

What happened in the first quarter was mainly a liquidity storm, and the deeper into this year we get, the more solvency becomes the key issue to be concerned about.

As the economic machine and its associated incomes came to a halt in Q1 of this year, the liquidity storm consisted of countless companies drawing on their revolving credit facilities from banks at the same time to get cash on their balance sheets (a corporate version of a bank run), the foreign sector scrambling for dollars to service dollar-denominated debts (and selling some of their U.S. Treasury reserves to get them), tens of millions of people losing their jobs in the United States and countless more losing jobs internationally, and virtually all markets (Treasuries, credit securities, equities, oil futures, precious metals futures) becoming very illiquid as sellers overwhelmed buyers.

Then, the unprecedented magnitude of fiscal and monetary policy response to this liquidity crisis flooded global markets with liquidity. As part of over $2.7 trillion in crisis aid from Congress, helicopter money checks were sent out to most American households, extra unemployment benefits were provided, small businesses received loans that can turn into grants (although that was one of the logistically problematic programs), funds were provided to various portions of the healthcare system, and bailouts were offered to certain industries. The Federal Reserve funded those fiscal programs by creating dollars ex nihilo and buying record amounts of Treasury securities with those new dollars, and they also bought mortgage-backed securities and set up a special purpose vehicle backed by the Treasury Department and allocations from Congress to buy corporate bonds and municipal bonds with loss protection. In addition, the Federal Reserve set up liquidity swaps with foreign central banks to provide dollars in exchange for foreign currency, which is an attempt to alleviate the global dollar shortage and prevent further foreign sector sales of Treasury securities.

This chart perhaps best sums up the economic shock. It's the nonfarm payroll number, which shows the 20 million jobs that were lost in April alone:

Chart Source: St. Louis Fed

With initial jobless claims still rolling in weekly by the millions (roughly 36 million in total so far), May is likely to see a deeper figure. After that, we'll see.

On the other hand, here's a chart that captures the liquidity response:

Chart Source: St. Louis Fed

The Federal Reserve increased their balance sheet by almost $3 trillion within a couple of months, which is already larger in magnitude in both absolute terms and as a percentage of GDP, than their immediate response during the 2008 crisis. In essence, they "print money digitally" to buy assets such as Treasuries and mortgage-backed securities, and to provide other central banks with currency swaps. Over half of that balance sheet increase involved buying Treasuries to fund the government's aforementioned fiscal response, and it's probably going a lot higher by the end of the year.

Some bankruptcies have already occurred, including well-known companies like Gold's Gym and J.C. Penney. This is the beginning of the solvency portion of the crisis. Some companies, even if they can get access to money at the moment (liquidity), simply have too much debt and a structurally noncompetitive business model (solvency), and need to either liquidate or restructure. The next several years are likely to be challenging for many companies with weak balance sheets, so make sure you know what you own.

A big topic in the financial media, or at least in the more critical or alternative financial media, has been the huge divergence between the stock market and the real economy.

This screenshot from CNBC made the social media rounds last month and expresses that divergence well:

Source: CNBC

Even as people continue to lose jobs and total employment continues to decline, the stock market bottomed in March and has rebounded very strongly since then. So we have what appears to be a divergence between Wall Street and Main Street. If that is the case, this has all sorts of implications.

A potential financial implication is what many equity bears have suggested: that this rally in stocks has been mostly an illusion and is destined to fall back down to economic reality. Recessions and bear markets generally have many strong rallies within them even as they eventually fall back into lower lows before eventually finding a bottom.

A potential political implication involves the perception that policymakers bailed out Wall Street more than Main Street and further contributed to increasing wealth concentration and crony capitalism. With $2.7 trillion in crisis funding signed into law so far, that's about $8,000 per capita or $21,000 per household, but how much aid has the median American on Main Street really received, directly or indirectly?

If we look back over the past three recessions, we actually see similar market behavior. It's just that the magnitude and time compression of this job loss was so unprecedented.

If we compare the Wilshire 5000 index (which represents virtually all of the U.S. stock market) to the 4-week moving average of initial jobless claims, the past three recessions show that the market tends to bottom roughly when initial claims hit their peak:

Chart Source: St. Louis Fed

In the early 1990's recession, the market bottomed slightly before initial jobless claims peaked. In the early 2000's recession, which was really more of an equity bubble with a very long stock market decline, the market bottomed a bit after initial jobless claims peaked. In the 2008/2009 recession, the market bottomed slightly before initial claims peaked.

We don't know if the March 23 stock market low was "the bottom" or just "a bottom". But if it happens to have been "the bottom", it occurred right before initial jobless claims peaked, just like in 2 of the past 3 recessions:

Chart Source: St. Louis Fed

Initial jobless claims reached almost 7 million at their worst point when the quarantine began, and the 4-week moving average reached nearly 6 million. That rate has now slowed to under 3 million lost jobs per week, which means that the total number of job losses continues to grow, but at a slower weekly pace than before.

Chart Source: St. Louis Fed

In other words, the market doesn't historically tend to bottom at the lowest point in total job losses and rebound when jobs start to come back. Instead, it tends to bottom closer to the highest rate-of-change period of job losses, which comes earlier. When those job losses are still coming in but at a slower pace, the stock market starts to see the light at the end of the tunnel, hopes that the light isn't an oncoming train, and starts working its way up on higher sentiment, usually with a ton of help from fiscal and monetary responses that throw money at the problem.

That doesn't necessarily make me a broad equity bull at the current time, though. This was a massive rally off the lows and has already started to trend sideways. Even if March 23 was "the bottom" for this cycle, there's a good probability that the equity market will grind around for a while, up and down. Market performance can be bad in real terms, over a near-term or long-term period of time, whether or not it makes lower lows. It can chop around for a while, go higher or lower within a wide range, and to what extent it does will likely depend on how much money that policymakers flood the system with to mitigate ongoing liquidity and solvency problems, as well as depending on investor sentiment.

Record S&P 500 Concentration

If we dig a little deeper, we can see that most of the stock market actually still does look like the real economy: down big and with little improvement yet.

The top five stocks in the S&P 500 consisting of Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Alphabet (GOOGL), and Facebook (FB) now make up over 20% of the index, which surpasses the amount of concentration that occurred even at the height of the Dotcom bubble:

Source: Goldman Sachs, via Business Insider

We have to look back to the 1980's and 1970's to find more concentration in the U.S. stock market than we have today. Back then, AT&T (T) and IBM (IBM) dominated the index, and the overall market was much smaller, so it was easier for companies to dominate it. AT&T was broken up, and IBM went on to gradually diminish in relative importance.

There were times when Exxon Mobile (XOM) and General Electric (GE) had the biggest spot in the S&P 500 as well, in the 1990's and 2000's. The future could always be different, but historically, being the top stock in the index has generally led to poor performance over the next 5-10 years relative to the rest of the index.

If we look at several indices' performance year-to-date (represented below by ETFs), we see that most of them other than the Nasdaq 100 and S&P 500 actually do look more like the economy:

The Nasdaq 100 (QQQ) is up the most, as the top five stocks account for over 40% of that index.

The S&P 500 (SPY) is next in terms of performance, since the same top five account for over 20% of that index.

The equal-weight S&P 500 (RSP), which has the same 500 companies but is weighted equally rather than weighted in terms of market capitalization, is far behind them. In fact, emerging markets (EEM), foreign developed markets (EFA), and the equal weight S&P 500, all have about the same performance this year.

Behind them are mid-cap stocks (MDY) and small cap value stocks (SLYV), which have dramatically underperformed. Certain sectors, such as the financial sector, have also deeply underperformed.

So, most stock market indices actually do look quite a bit like the real economy, with a big fall and little recovery. However, the top 5 mega-cap stocks have held up the major American stock market indices like Atlas holding up the world, and reached levels of concentration not seen in nearly four decades.

It's notable that this has not been the case internationally. MSCI equal-weighted international indices (whether it's emerging markets, or the full all-country ex-USA index) have performed about the same as their market-cap weighted versions year-to-date as of the end of April.

So, this has not really been a case of a performance differential between U.S. stocks vs. international stocks broadly. It has been a case of the top five U.S. stocks outperforming just about everything else, including the rest of the American stock market.

Fundamentals or Valuation?

This U.S. mega-cap stock market concentration is partly from fundamentals. For example, Amazon has of course had a far better time than most physical retailers in this quarantine environment, so the performance gap between itself and them has widened even more.

However, valuation is also a big factor. Many stocks are rightfully trading at historically moderate-to-low valuations, pricing in the high probability of substantial economic pain ahead. However, investors have flocked into these tech titan stocks in search of strong balance sheets and seemingly quarantine-resistant business models, almost at any price.

Apple stock, for example, isn't this high purely on bigger fundamentals; it also received a valuation premium by the market over what were rather flat fundamentals in recent years, and hasn't really lost any of its high valuation this year:

Chart Source: F.A.S.T. Graphs

Each valuation metric has its pros and cons. This chart shows that Apple is more expensive than its 5-year average in terms of price-to-sales, price-to-book, and dividend yield:

And we can look at the "P/E 5" ratio, which divides the current price of a stock by the average of the past five years of real earnings and gives us a nice snapshot for how the price is relatively to a smoothed baseline of earnings. By that metric, Apple is also quite expensive relative to its average. I added the EV/EBITDA ratio on that chart as well:

With geopolitical tensions increasing between China and the United States again, Apple has risks related to Chinese supply chain issues and access to the large Chinese consumer market. It also has general risks related to people not upgrading their premium-priced phones as frequently due to being tight on cash. The iPhone market is quite saturated, so the company is increasingly reliant on services and accessories to further monetize its existing user base.

Apple has plenty of cash, but whether it's a good buy becomes a matter of growth and valuation. Hypothetically, if the company does absolutely fine fundamentally, but the valuation merely falls to its 5-year average, it could have a 30% price cut down to $200/share and frankly, nothing would be unusual about that. Or maybe it won't, and the valuation averages will gradually catch up to where they are now for Apple. A lot of it depends on investor sentiment.

I'm not looking to single Apple out here, and am instead just trying to point out some of the valuation risks among some of the mega-caps that, if they were to turn down, would broadly affect the S&P 500.

Going forward, I continue to like precious metals within a portfolio mix, but am also strongly interested in beaten-down stocks that specifically have strong balance sheets.

I'm not interested in beaten-down highly-indebted businesses, because they are likely to face ongoing solvency issues. However, high-quality companies in the U.S. and internationally with a) strong balance sheets and b) that happen to operate in cyclical industries but have good long-term prospects, is specifically the subset of companies that may have a lot of potential over the long run from current levels.

At this point, investors would do well to consider the meaning of the morbid phrase, "you don't have to outrun the bear, you just have to outrun your friend." This hypothetical scenario refers to a bunch of human campers trying to outrun a hungry bear that is chasing them (and which is faster than humans, but can't catch all of them).

In other words, policymakers around the world can't afford to let a massive deflationary economic collapse occur, and for millions and millions of people to be unable to afford the necessities of life and for half of large companies to go out of business, so they will be forced to keep the stimulus taps open, funded with printed money, with a willingness to devalue currency to avoid the worst case economic scenario. Cheap stocks that survive and go on to rebound, are likely an opportune set of investments.

That doesn't mean that the large stock indices won't go down; in fact I think they've come too far too fast and could use a reality check. And it certainly doesn't mean every company is safe; many of the weaker ones with a lot of leverage are dead weight and I wouldn't touch them.

But a sweet spot in my view is companies that have recently become cheap and that will have a tough 2020 and 2021, but have among the strongest balance sheets in their industry and structurally strong business models in a post-virus scenario. If we start with the premise that, say, the whole steel industry won't go bankrupt, or the whole automotive industry, or the whole multifamily housing industry, or the whole banking industry, and so forth (especially all at once in a mass collapse), then the question becomes, "which players are the strongest in their industries, the best-positioned to outlast their peers and make it through to the next reflationary cycle?" That's where I am looking and buying for some of my risk exposure.

See also What Happened In The Bond Markets Last Week? Muni Fortnightly, July 20, 2020 on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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