In Bear Market Rally, Some Say They’ve Got It All Figured Out

“There is no dichotomy in reality”, Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management told Bloomberg, for a piece making the case for the dramatic bounce in equities off last month’s lows.

America has been “so good at performing our recommended treatment [and] we’re seeing bad data because good social distancing means a better virus outlook”, he added. “Less social distancing [is] leading to a rising market on the belief the data will get better”.

With all due respect to Brent, that’s a kind of silly “heads I win, tails you lose” sort of argument.

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We’re seeing bad data because the economy is shut down. The fact that there’s a solid, public health rationale for shutting it down in the first place doesn’t mitigate the loss of operating income to businesses, nor does it make any of the 22 million Americans who lost their jobs over the past four weeks any less jobless.

There’s no such thing as being “good” at social distancing vis-à-vis businesses that are closed. America can pat itself on the back for refraining from non-economic activities that may risk spreading the virus. So, for example, we can laud our own self-restraint when it comes to things like large social gatherings. But not going to a movie theatre that isn’t open or “refraining” from going out for drinks at a bar where the doors are locked, isn’t a credit to anybody’s discipline.

The point isn’t to pick on Brent, it’s just to say that the better argument for the rally is simply that Q2 is done for. The US economy is, in fact, in a depression. The reason it makes sense to buy stocks in a depression is because this isn’t a “classic” depression, it’s an “induced coma”. Assuming the oxygen being administered by the Fed and Congress is sufficient, the patient can be woken back up, if not at the snap of Trump’s fingers, at least in phases, based on common sense, tailored plans developed by local officials.

That’s as opposed to a scenario where the underlying problem is the economy itself, or some feature of that economy.

I’ve said repeatedly that I don’t necessarily disagree with that. Clearly, the economy cannot stay idled forever, and if it does, it presumably means some unforeseeable (and entirely bad) outcome around COVID-19 has been realized. At that point, there will be more pressing matters at hand than worrying about whether or not it makes sense to buy the S&P at what, if we knew what earnings really were right now, would be a comically high multiple.

But there are two problems, both of which I’ve discussed here previously, but which I want to reiterate because this is clearly the only debate that counts right now.

The first problem is that we may be trafficking in nonsense. Stripped of any and all nuance, the notion that it makes sense to buy stocks because the underlying economy is sound when it’s open, is like saying it’s a good idea to purchase a claim on the future earnings stream of an individual who’s in a coma due to a freak accident that doctors project won’t ultimately cause lasting damage. You may have every reason to believe that person will return to perfect health in relatively short order, and that person may well be a good earner when healthy, but your investment is still a dicey proposition, to say the least.

I mentioned this a few days ago in conjunction with the release of dire factory output data.

One does have to wonder what is even meant by “fundamentals” in a scenario where economic activity has effectively ceased, I wrote, noting that there’s something profoundly strange about suggesting that economic activity itself is somehow not a reflection of the “fundamentals”.

The second problem is that it’s not entirely clear the underlying economy is healthy. Deutsche Bank’s Aleksandar Kocic described the reality in a Friday note. “In the absence of a major disruption, the system is capable of moving along by collecting small installments of rent (‘clipping the coupons’) from a large segment of the population”, he said. “However, if an exogenous shock disrupts the fragile order of these cashflows, there is a chain reaction of collective insolvency ready to sink the entire system”.

That is not a “fundamentally sound” economy. It’s essentially serfdom. America’s “booming” economy is, in fact, inherently unstable, characterized by “massive negative convexity”, Kocic wrote.

Credit Suisse’s James Sweeney underscored some of these points in his latest quarterly economic outlook appropriately called “Wasteland”.

“The many fixed short term obligations that firms and households face are an Achilles heel of the world’s financial system: the money flows simply cannot stop”, he wrote.

You’re reminded that Sweeney co-authored Zoltan Pozsar’s classic March 3 note, which set out, in painstaking detail, the chain of events that was likely to unfold over the subsequent five weeks. Sweeney echoes his contribution to that exposition in his latest, and those familiar with the March 3 piece with Pozsar will recognize many of the points. To wit, from Sweeney:

Millions of businesses and billions of households now have cash balances which are far from what was expected or intended just a few months ago. For some, cash is higher than expected, because they have stopped spending on many things or soon will receive government help. For others, cash is lower as revenues have had a sudden stop. Predictably, this circumstance has impacted the financial system. Firms have tapped credit lines, switched to a risk -averse cash hoarding mode, fled illiquid investments, sold safe investments to raise money, and reassessed investment and hiring plans. These changes perturb bank funding markets in myriad ways, and a funding and illiquidity crisis quickly arose. 

That’s the channel through which a public health crisis briefly became a financial crisis. Some of the dislocations in funding markets linger, but most have been addressed to varying degrees of adequacy by the Fed.

As for households, it’s an open question. Steve Mnuchin’s “bridge liquidity” clearly won’t last long for families and individuals living paycheck-to-paycheck.

And, remember, the fiscal help cannot properly be described as “stimulus” right now, because there’s nothing to stimulate – the economy is shuttered. All we’re doing is staving off the day when a liquidity pinch becomes a solvency crisis.

“Businesses that are shut down and households that are staying home cannot spend this money in the usual way in the short term, but they can use it to pay bills”, Credit Suisse’s Sweeney goes on to say, noting that “it will likely become true ‘stimulus’ when the recovery begins and normal economic life resumes somewhat”.

But, as ever, there’s a caveat. The only way “bridge liquidity” to businesses and households can become “stimulus” is if economic activity resumes. Short of calling a moratorium on rent, utilities, mortgage payments and all other fixed costs for businesses and households (which would entail the federal government making utility companies, landlords, banks and lenders whole, because one person’s debt is everywhere and always someone else’s asset), the window for restarting the economy based solely on the current virus relief packages appears quite small indeed.

As Sweeney puts it, any fiscal package can only become “stimulus” as long as “the shutdowns have not lasted so long that they deplete these cash balances so that a new round of missed payments occurs”.

None of this is an argument for restarting economic activity prematurely. Regular readers are fully apprised of my views on the extent to which doing so risks the worst possible outcome for public health, markets and the broad economy.

Rather, the above is just meant to underscore the notion that it’s perilous to justify chasing a bear market rally based on simplistic arguments. Remember, this is hardly the first time stocks have surged during bear markets.

Granted, Occam’s razor is a sturdy crutch if ever there was one, and Brent Schutte (mentioned here at the outset) may end up looking like one very smart fellow to have leaned on it.

But even as there’s always a certain elegance in simplicity, this is one time when that elegance might not translate to veracity.

On that note, I’ll leave you with one last passage from Credit Suisse’s Sweeney:

Imperfect economists rely on imperfect epidemiologists who rely on imperfect virologists who say that so much remains unknown about COVID -19. Because a virus is essentially the mutating, breeding swarm of a quasi -species, even less is known about the form that the virus will take months from now, including basic essentials such as modes of contagion, mortality risk, and the efficacy of treatments. These can change as the pressures of natural selection and speedy RNA mutations operate to benign or ill effect.

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