Reality Check

By Bill Ehrman:

There has been a huge disconnect between stock market prices and fundamentals/valuations of those companies hurt most by the pandemic. This may finally be changing as reality sets in. Somehow, the markets woke up after hearing comments on Wednesday from the Fed Chairman Powell that monetary policy will not change, holding funds rate near 0, until at least the end of 2022 as it will take that long for the economy to fully recover, and then some, from the punitive effects of the pandemic.

While Powell believes that a powerful economic recovery has begun, the new normal economic environment will be challenged by higher than normal unemployment and persistent low inflation. While we agree that unemployment will stay stubbornly high as corporations have learned to do more with less and many small businesses will not re-open. We disagree with the Fed's view on inflation as all the monetary and financial stimulus will most likely come back to haunt us on the other side. Global competition, technology, and disruptors are here to stay which will put a lid on inflation before getting out of hand, something that we have been espousing for years.

The financial markets are volaitile, changing on a dime from outright exuberance that the recovery will be a V to downright pessimism that the recovery will be drawn out fraught with risk of a resurgence in the pandemic.

We remain optimistic that the recovery will be stronger than we initially thought as states re-open. However, many business sectors, including those small businesses hurt by the pandemic, will not return to profitable operating rates, if at all, until there is enough testing, broad contact tracing, therapeutics, and vaccines on the horizon.

We listened to the heads of research at J&J (JNJ), Lilly (LLY), Regeneron (REGN) and Moderna (MRNA) this week. Each was very optimistic that we will not only have therapeutics by fall but also a vaccine before the end of the year which is 6 months ahead of earlier expectations. Vaccine production has already begun and hundreds of millions of doses will be available by early 2021. Finally, we also continue to hear that physicians have made great strides in treating the virus reducing death rates meaningfully. All good news.

The Fed meeting and Powell's subsequent conference call last week resulted in investors doing a reality check on their economic outlook and the impact on the rebound in profitability of companies most hit by the pandemic.

While the Fed questioned a V recovery, it said that a recovery had clearly begun, but that it would take nearly 2 years to fully recover from an anticipated 6.5% decline in real GNP in 2020. The Fed projected an unemployment rate close to 9.3% by the end of the year declining only to slightly less than 5% by the end of 2022. We, too, believe that unemployment will not return to prior low numbers as corporations have learned to do more with less and many small businesses will just not make it to the other side. The Fed does not see any inflationary pressure for a long time as there will be a lot of slack in the economy until after 2022. Therefore, the Fed concluded that maintaining essentially a zero-based policy for several years is warranted at this time. Wow!

While it's the Fed's role to provide liquidity and stability to the economy and financial markets, Powell made it clear again that it is Federal government's role to provide programs that not only financially support individuals and companies in need, but also to implement programs that stimulate demand. So far, the government has provided money only to keep individuals and companies in need afloat. Interestingly, the government has nearly $1 trillion left to spend from prior programs which will be completed before July 1st at which point the government is likely to pass another program targeted at small businesses and industries that are having the most difficulty opening as a result of the virus. But, as Powell said, we will need demand- focused programs to really get the economy going but none are likely in an election year. We do expect some in 2021.

As I always emphasize, we are investors, not traders. We take a longer-term outlook rather than day-to-day. There is much more liquidity being provided by the Fed and all monetary bodies around the world than the real economy needs which forces investors further out on the risk curve. It is far more important to focus on the direction of the economy rather than the speed of the recovery. Our economy has begun to recover as states have re-opened. We fully expect a rise in the number of coronavirus cases as people go out more but hopefully never to the point that states need to shut down again. There is a general belief, as stated by Mnuchin, that we will not shut down as deeply as we just experienced, should there be an outbreak in fall. We have learned so much about how to handle the situation. We agree. What we have learned about how to prepare and manage will reduce contagion in the future.

We are optimistic that there will be therapeutics to handle outbreaks in the fall and vaccines ready to go by the end of this year or early next which would support a stronger economic recovery in 2021 and 2022 than currently envisioned.

This is a good time to be long stocks. But not all stocks are equal, at least for now. We would continue to avoid stocks in those companies where demand will not return to past levels for a couple of years until the economy fully recovers and a therapeutic as well as a vaccine are available. Earnings for most of these companies cannot support today's stock prices even looking out 2 years.

On the other hand, we continue to invest in those companies that have benefitted from the new paradigm. We continue to hear from managements that technology spending has been accelerated at higher levels and will remain so in the new normal economy. This new phenomenon has just begun and has many years to run. Increased use of the internet is a fact of life and everyone needs to have accessibility using a computer, tablet and/or smart phone. 5G is coming as well, and there will be huge increase in capacity for data centers and cloud storage. Semis and security providers are clear winners here. On the other hand, we recently added some stocks with economic sensitivity as we do expect a steady sequential improvement in the economy. These companies have the earnings and cash flow to support higher prices today. While the recovery may not be a V as many hope, it will also not be an elongated U either. Rather, a steady build that will then accelerate once we have a therapeutic and even more so after a vaccine. An investor looks over this valley.

We are favorably inclined to stocks and commodities but not bonds. We expect the yield curve to steepen over time as the economy improves. If long term economic growth is just 2% and inflation averages just 1.5%, should the long-term bond be yielding under 1.5%? Doubt it!

Our weekly webinar will be held on Monday, June 15th at 8:30 am EST. Remember to review all the facts; pause, reflect and consider mindset shifts; turn off your cable news; do independent research and… Invest Accordingly!

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

See also Non-OPEC Oil Production Collapses In April 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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