Looking For Clues About Where The Market Is Headed Next

The Covid-19 pandemic and its impact on health, the market, and the economy has knocked us off the rails. I wish I had a good answer to the burning question of when it will be safe to get back into the market, but I don't. And anyone who claims to have the answer is simply guessing.

Looking for clues

In this article I'm going to look at three things. First, the facts as we know them. Second, the assumptions and narratives that are gaining the most traction in the media. And third, the range of possible outcomes and their likelihood.

When you're off the rails, as we are now, the potential impact of unknowns is staggering. I'll go through the ones I think are the most relevant in the search for clues about where the pandemic, the market, and the economy  may be headed next.

The facts as we know them.

• There are 2.4 million confirmed cases of Covid-19 globally, and 165,000 confirmed deaths. (7% death rate.)
• 30% of Americans say coronavirus was made in a lab, according to a survey of nearly 9,000 adults in the U.S. conducted from March 10 to 16, 2020 by the Pew Research Center, a nonprofit, nonpartisan think tank.
• Most schools, non-essential businesses, and other public gathering places have been in lock-down for the last six weeks.
• 22 million Americans have filed for unemployment benefits in the last 4 weeks.
• The U.S. government is providing at least $2.2 trillion of liquidity to individuals, corporations, and capital markets.
• Corporate stock buybacks and dividends are being reduced, suspended, or eliminated. Corporate capital expenditures are also being reduced or suspended.
• The price of crude oil has dropped from $63 to $18 per barrel since January 1, 2020.
• Gold is up 11% since the start of 2020.
• After a -5.6% decline, the bond market is now up 2.7% YTD. Long-term treasuries lead the pack. 
• The U.S. stock market declined 34% from February 19 to March 23, 2020. It has since recovered about half of that decline.
• Analysts are cutting earnings estimates as companies announce sharply lower profits.

The top ten performing stocks in the S&P 500 YTD are:

• Regeneron Pharmaceuticals Inc (XNAS:REGN)
• Newmont Corporation (XNYS:NEM)
• Citrix Systems Inc (XNAS:CTXS)
• Netflix Inc (XNAS:NFLX)
• SBA Communications Corp (XNAS:SBAC)
• Gilead Sciences Inc (XNAS:GILD)
• Amazon.com Inc (XNAS:AMZN)
• Clorox Co (XNYS:CLX)
• Digital Realty Trust Inc (XNYS:DLR)
• NVIDIA Corp (XNAS:NVDA)

(These ten stocks are up between 24% and 51% in 2020.)

Assumptions and popular media narratives.

• The pandemic has reached its peak and the worst is behind us.
• An effective vaccine for Covid-19 will be widely available by mid-summer 2020.
• As soon as mid-May, businesses will start to reopen and life will begin to return to normal.
• Schools, churches, bars, restaurants, shopping malls, casinos, and even cruise ships will be back on line by Labor Day.
• Central banks and the U.S. Treasury will continue to do whatever it takes to soften the economic blow. More bailouts, liquidity injections, and fiscal stimulus are coming. 
• After buying corporate bonds, the Fed may even begin to buy equities to support the stock market.
• A new bull market in stocks has already arrived and will continue in the future.
• Corporate earnings will take serious hits in Q1 & Q2, but they will recover by year-end 2020. 2021 will see record high profits for the S&P 500.
• Stock market volatility has been cut in half since the market bottom and will continue to decline.
• Inflation will remain subdued, regardless of the significant expansion of the Fed balance sheet.
• The unemployment rate will return to historic lows by year-end 2020.
• U.S. GDP will be negative in Q2, but positive in Q3 and beyond. A deep but brief recession.

The range of possible outcomes and their likelihood.

As a forward-looking mechanism, the stock market has recently been assuming that many of the above assumptions and media narratives will in fact come to pass. It's likely that at least some of them will, but I want to know how likely it is that enough of them will come to pass in order to sustain the market rally and the attendant investor and consumer optimism that has been driving it.

Let's begin with a simple range of three possible outcomes - optimistic, most likely, and pessimistic - and assign arbitrary but thoughtful probabilities to each.

Optimistic - probability 15%

The pandemic has crested; businesses start to reopen in early May; the economy suffers a single quarter of negative growth and rebounds quickly; corporate earnings rebound by end of 2020; laid off or furloughed employees return to work by the Fall; social distancing becomes a quaint idea by mid 2021.

Most likely - probability 70%

The pandemic mostly crests but new cases are discovered as testing reaches full capacity; new virus hot spots pop up in unexpected places; the economy suffers a second quarter of negative growth; corporate earnings continue to decline as consumers are more reluctant than anticipated to resume spending; the unemployment rate remains stubbornly high as companies are reluctant to rehire and many furloughed workers drop out of the labor force; social distancing becomes the new normal, putting long lasting pressure on leisure and travel businesses.

Pessimistic - probability 15%

The rush to reopen the economy causes a second wave of virus cases; companies are forced to shut down for a second time, and they are reluctant to reopen until the coast is truly clear; unemployment rises again; corporate earnings continue to decline; bankruptcies begin to increase; state governments and pension plans take a second hit; the economy faces a long and painful period of low growth; another lost decade for the stock market as prices reach lower lows.

It appears that investors are largely buying into the optimistic scenario.

Nobody knows squat

There is no shortage of theories being offered by the financial media to explain the sharp market recovery.
Some market pundits point to the unprecedented amount of money being spent by central banks. Others cite a ‘wall of liquidity’ from investors looking for alternatives to low- yielding government bonds. 

Still others see signs of Covid-19 "curve flattening" as an indication that social distancing will soon be a thing of the past. And let's not forget our old friend FOMO – fear of missing out – as investors rush back into rising markets, worried they may fall behind their peers. The rally may also be amplified by computer-driven investment programs that follow trends in market movement. After all, about 80% of all trading today is generated by computer algorithms.

Today, things may be getting less bad, but let’s get real for a moment. Here are some of the headwinds we're facing:

• probable sovereign debt downgrades
• massive unemployment
• huge and unsustainable increases in public sector debt, including via unprecedented commitments to private sector debt obligations
• an unknown path of pandemic containment
• serious doubts about whether innovations like globalization, just-in-time inventories, and complex supply and finance chains can be restored to what they were just a few months ago.
• Global GDP is estimated to contract by 2-4% this year
• corporate profits will probably fall about 20% this year

Given these headwinds, equities should trade 20-25% below their pre-pandemic peaks for the remainder of 2020. And what about next year?

How long will it take to recover from the disruptions to global financing and supply chains? At what point will investors have to face the consequences of fiscal austerity? How should they factor in a sustained higher savings rate and its negative impacts on household or corporate spending?

What about social distancing? Will people readily return to crowded spaces like bars, restaurants, casinos, cruise ships, airplanes, public transportation, school classrooms and the like? 

Some people will argue that unprecedented monetary policy easing, government guarantees of private sector debt, and fiscal stimulus make for a brighter future and offset the negatives described above. I hope they're right, but I'm not so sure. 

I think it will be a long, cold winter before things return to normal.